Real interest rate parity with Flexible Fourier stationary test for Central and Eastern European countries

This study applies stationary test with a Fourier function proposed by Enders and Lee (2012) to test the validity of long-run real interest rate parity (RIRP) to assess the non-stationary properties of the real interest rate convergence for twelve Central and Eastern European (CEE) countries. We find that our approximation has higher power to detect U-shaped breaks and smooth breaks than linear method if the true data generating process of interest rate convergence is in fact a stationary non-linear process. We examine the validity of RIRP from the non-linear point of view and provide robust evidence clearly indicating that RIRP holds true for nine CEE countries. Our findings point out that their interest rate adjustment is mean reversion towards RIRP equilibrium values in a non-linear way.     

Uncovered interest parity in Central and Eastern Europe: Expectations and structural breaks

This paper examines the empirical validity of the hypothesis of uncovered interest parity (UIP) using data from five Central and Eastern European countries with floating exchange rates for the period 2003 to 2014. The analysis includes forward‐looking as well as static expectations and allows for different types of structural break. The variable depicting the deviation from strict UIP is stationary when expectations are forward looking, suggesting that it is not possible to reject the UIP hypothesis with a constant risk premium. The deviation from strict UIP is however typically not stationary when expectations are static, even when structural breaks are incorporated, leading to the rejection of the UIP hypothesis with a constant risk premium. The results underscore the central role of expectations for the UIP hypothesis.     

The validity of uncovered interest parity: Evidence from african members and non-member of the organisation of petroleum exporting countries (OPEC)

This paper re-examines uncovered interest parity (UIP) puzzle using Africa where there is dearth of studies. It extends the previous literature in the following ways. It captures the heterogeneity (oil and non-oil sources of shocks) in the region by considering both African members of the Organisation of Petroleum Exporting Countries- OPEC (Algeria, Nigeria and Angola) and non-member (South Africa) to ensure generalisation of findings. It also explores asymmetric exchange rate responses to diverse monetary policy stances from a new dimension by explicitly measuring asymmetries and capturing long- and short-run dynamics using the new non-linear autoregressive distributed lag (NARDL) and asymmetric component AC-GARCH models along with other recent methods for results' robustness. Results from alternative methods show that UIP fails to hold in the African members and non-member of OPEC which is attributable to capital mobility restrictions and currency risk. However, asymmetric and permanent/transitory exchange rate response to monetary policy stances was noticed with little evidence of risk premium dynamics and role of price level instability in UIP validity.     

Uncovering the link between a flexible exchange rate and fundamentals: the case of Central and Eastern European economies

This article examines the link between a nominal exchange rate and macrofundamentals in Central and Eastern European (CEE) countries. We use the model based on the monetary policy rule as a theoretical framework that explains the relations between the exchange rate and price level, risk premium, output gap, and expected inflation. It allows for endogeneity of the monetary policy – the issue ignored in the widely used monetary model. The sample covers the period January 2000 – December 2014, so the data are not plagued by high-inflation differentials characteristic for the early transition period and include countries with relatively flexible exchange rates. Our empirical strategy employs the panel error correction model that allows for cross-sectional dependence and a series of panel causality tests. The main finding is that the nominal exchange rates in CEE countries are not disconnected from macrofundamentals implied by the Taylor rule-based model. More specifically, we find that there is a strong cross-sectional dependence among CEE countries, exchange rates Granger-cause macrofundamentals and tend to revert to the long-run relation, and that the results are robust to the ‘extraordinary circumstances’ argument, i.e. do not rest on the dynamics during the global financial crisis.     

An Incomplete Markets Explanation of the Uncovered Interest Rate Parity Puzzle

A large literature attributes failure of uncovered interest rate parity (UIP) to the existence of a time‐varying risk premium. This paper presents a mechanism in a simple two‐country two‐good endowment economy with incomplete markets that generates sizeable deviations from UIP. In a parameterization where international wealth effects are important, liquidity constraints on an internationally traded bond and agents’ strong resulting precautionary motives successfully generates a time‐varying risk premium: countries that have accumulated large outstanding external positions have, being closer to the constraints, stronger precautionary motives and their asset carries a risk premium.     

Forward-premium puzzle: is it time to abandon the usual regression?

The forward premium puzzle is usually evidenced by the rejection of the null hypothesis in the uncovered interest parity (UIP) regression. Because this parity need only hold in a risk-neutral world, a risk adjustment term is missing from the equation if speculation in foreign exchange markets is risky. We deal with this issue following the literature which assumes that discounted returns on foreign government bonds are log-normal, so we can linearize the Euler pricing equations (in level) and obtain a modified UIP system for which the risk adjustment term is obtained by applying to the pricing kernel-based relations a generalized autoregressive conditional heteroscedasticity-in-mean model. However, here we innovate by adopting a methodology which differs from all these related works. We construct and use a stochastic discount factor that does not depend on a specific model, by residing in the space of returns which we extract from the data by simply imposing the orthogonality restrictions represented by the Euler equations. So, we devise a purely statistical pricing kernel that performs well in in-sample level equations. Somewhat disappointingly, the risk premium inclusion in the conventional regression changes neither the significance nor the magnitude of the forecasting power of the forward premium for most currencies we study. The contrasting performance of the tests in level and in logs suggests that linearization may be to blame.     

Uncovered Interest Parity at Long Horizons: Evidence on Emerging Economies*

This paper estimates uncovered interest parity (UIP) at long horizons using bilateral US dollar rates vis‐à‐vis mature economy and emerging market currencies. The paper finds support in favor of UIP for dollar rates vis‐à‐vis major mature economy currencies, but far less against emerging market currencies. There are also signs that political risk and the exchange risk premium help explain the empirical failure of UIP for these latter currencies. This suggests that whether UIP holds depends more on the currency than on the horizon.     

Flexible Fourier unit root test of unemployment for PIIGS countries

In this empirical study, we apply the flexible Fourier unit root test proposed by Enders and Lee (2012) to re-examine the hysteresis hypothesis of unemployment for PIIGS (Portugal, Ireland, Italy, Greece, and Spain) countries over the period from 1960 to 2011. We find that the Fourier unit root test has greater power than a linear method if the true data generating process of unemployment is a stationarity, non-linear process of an unknown form with structural change. The hysteresis in unemployment is confirmed for all PIIGS countries, with the exception of Portugal and Spain, when the Fourier unit root test is conducted.     

The Global Financial Crisis and Stochastic Convergence in the Euro Area

This paper analyzes the issue of convergence in the original Euro Area countries, and assesses the effect of the global financial crisis on the process of convergence. In particular, we consider whether the global financial crisis pulled the 12 economies of the Euro Area together or pushed them apart. We investigate the dynamics of stochastic convergence of the original Euro Area countries for inflation rates, nominal interest rates, and real interest rates. We test for convergence relative to Germany, taken as the benchmark for core EU standards, using monthly data over the period January 2001 to September 2010. We examine, in a time-series framework, three different profiles of the convergence process: linear convergence, nonlinear convergence, and linear segmented convergence. Our findings both contradict and support convergence. Stochastic convergence implies the rejection of a unit root in the inflation rate, nominal interest rate, and real interest rate differentials. We find that the differentials are consistent with a unit-root hypothesis when the alternative hypothesis is a stationary process with a linear trend. We frequently, but not always, reject the unit-root hypothesis when the alternative is a stationary process with a broken trend. We also note that the current financial crisis plays a significant role in dating the breaks.     

On the Joint Test of the Uncovered Interest Parity and the Ex‐ante Purchasing Power Parity

This study revisits the relation between the uncovered interest parity (UIP), the ex‐ante purchasing power parity (EXPPP) and the real interest parity (RIP) for the UK and Japanese vs US data. The original contribution is on developing some joint coefficient‐based tests, obtained by rewriting the UIP, the EXPPP and the RIP as a set of cross‐equation restrictions in a vector autoregression (VAR) framework. Test results point to a “forward premium” bias in both the UIP and the EXPPP. The latter result is novel in the literature and stems from testing the PPP in expectational terms. Moreover, the results suggest a currency‐dependent pattern for the UIP, contrarily to the EXPPP equation. Finally, it is shown that conditioning the VAR on M3 growth differential has important explanatory power in resolving the aforementioned biases in both the UIP and EXPPP equations for the UK vs US data. At the same time, variables having a strong forward‐looking component (i.e. share prices) help recover a unitary coefficient in the UIP equation.     

ARDL panel estimation of stock market indices and macroeconomic environment of CEE and SEE countries in the last decade of transition

We tested the hypothesis of the procyclicality of stock exchanges regarding the economic activity of CEE and SEE countries, to measure the level of financial integration during the last decade of the transition period, and to compare these two groups of emerging countries. Our ARDL panel estimates support the hypothesis of procyclicality in the transition period in the CEE and SEE regions, and further financial integration, due to the opening up of the market economy and repricing of systematic risk, followed by large capital inflows, trade liberalization and industrial production, along with the implementation of institutional reforms regarding EU integration. In addition, the significant positive coefficient of capital inflows and negative coefficient of unemployment rate in the CEE and SEE panel ARDL results confirm the volatility of the transition process, as is obvious in higher industrial production, followed by the significant impact of import on CEE countries and the much higher significant impact of export on SEE countries.     

Revisiting purchasing power parity for major OPEC countries: evidence based on nonlinear panel unit-root tests

In this study, we apply nonlinear panel unit-root test to assess the nonstationary properties of the real exchange rate for seven major Organization of the Petroleum Exporting Countries (OPEC). We find that nonlinear panel unit-root test has higher power than linear method suggested by Breuer et al. (2001 Breuer, J. B., McNown, R. and Wallace, M. S. 2001. Misleading inferences from panel unit-root tests with an illustration from purchasing power parity. Review of International Economics, 9: 482–93. [Crossref] , [Google Scholar]) if the true data generating process of exchange rate is in fact a stationary nonlinear process. We re-examine the validity of Purchasing Power Parity (PPP) from the panel nonlinear point of view and provide robust evidence clearly indicating that PPP holds true for four countries, namely Angola, Indonesia, Iran and Saudi Arabia. Our findings point out their exchange rate adjustment is mean reversion towards PPP equilibrium values in a nonlinear way.     

Uncovered Interest Parity Revisited

A standard empirical finding in international finance is that countries with high nominal interest rates experience appreciations of their currencies, in contrast to predictions based on uncovered interest parity (UIP). However, tests of UIP have almost exclusively relied on data on short-term interest rates. In this paper, UIP is tested on long-term government bond yields. Since the presence of coupon payments induces a measurement error between the observed data and true returns, several different proxies for the latter are constructed. Furthermore, instrumental variable techniques are used. In contrast to thetypical finding, the results are rather favorable to UIP.     

On real interest rate persistence: the role of breaks

The role of structural breaks in long spans of ex-post real interest rates for 10 industrialized countries is studied. First, the persistence of the real interest is assessed with newly proposed low-frequency tests of Müller and Watson (2008). Second, the test of Leybourne et al. (2007) for a change in persistence of a time series is applied to the real interest rate. The results show that real interest rates over the full sample period do not fit a covariance-stationary or unit-root model, nor a fractionally integrated, near-unit-root or local-level model. Instead, the persistence of real rates changes over time and there are periods when the real rate is covariance-stationary and other periods when it follows a unit-root process.     

COMMON FACTORS OF THE EXCHANGE RISK PREMIUM IN EMERGING EUROPEAN MARKETS

Existing empirical evidence suggests that the Uncovered Interest Rate Parity condition may not hold due to an exchange risk premium. For a panel dataset of eleven emerging European economies we decompose this exchange risk premium into an idiosyncratic (country‐specific) element and a common factor using a principal components approach. We present evidence of stationary idiosyncratic and common factors. This result leads to the conclusion of a stationary risk premium for these countries, which is consistent with previous studies often documenting a stationary premium in advanced countries. Furthermore, we report that the variation in the premium is largely attributable to a common factor influenced by economic developments in the United States.     

Does output have a unit root? New international evidence

In this paper unit-root tests for per capita output of 12 OECD countries are performed. Using traditional unit-root tests, it follows that the unit-root hypothesis cannot be rejected except for the US. However, following the approach of Perron (1989), which takes shifts in mean and/or trend into account, the null hypothesis of a unit-root can be rejected in most countries in our sample. In contrast to Perron, a method suggested by Christiano (1992)is used to determine the break date endogenously.     

Trade between Euro zone and Arab countries: a panel study

We present empirical evidence regarding unemployment dynamics for women and men in eight OECD countries. Unit-root tests are used to examine the unemployment dynamics of women and men. Failure to reject the unit-root hypothesis is consistent with unemployment hysteresis. Rejection of the unit-root hypothesis indicates that unemployment dynamics are best explained by the natural rate of unemployment or the structuralist view. We find evidence of gender differences in unemployment dynamics in Canada, Germany and the US, but not in other countries. While there are some differences in the extent of persistence across gender and across countries, the degree of persistence for both female and male unemployment rates is fairly low in all countries. Our results, therefore, contrast with substantial empirical evidence of high levels of unemployment persistence in European countries.     

Mean Reversion of Short‐run Interest Rates in Emerging Countries*

In this paper we examine the stochastic behavior of short‐run interest rates in several emerging countries using fractional integration techniques. We allow for a much richer flexibility in the dynamic behavior of the series than the classical representations based on I(0) or I(1) processes. It appears that for Singapore and Thailand nominal interest rates are mean‐reverting, whereas for Mexico, Malaysia, the Philippines, and Korea, the presence of a unit‐root test depends on the assumptions regarding the residuals’ autocorrelation. The results also suggest that uncovered interest parity (UIP) can only hold for two emerging countries. For the other countries, the stabilization policies in the aftermath of the currency crises have led to the rejection of the UIP hypothesis.     

Revisiting Purchasing Power Parity in OECD

This study revisits Purchasing Power Parity theory (PPP) in the 34 OECD countries during January 1994–August 2013. We use a new panel stationary test with both sharp breaks and smooth shifts, a novel approach to panel unit-root testing, proposed by Bahmani–Oskooee et al. (2014). The results indicate that the PPP holds in half of the 34 OECD countries. These results indicate the importance of proper modelling of both sharp breaks and smooth shifts in real effective exchange rate series of OECD countries.     

The nature of regional unemployment in Italy

Taking as a starting point the evidence of growing disparities for most of the 1984–2007 period, this article investigates the nature of regional unemployment in Italy. In particular, we assess whether the Italian regional unemployment rates contain a unit root and are, thus, subject to pure hysteresis, considering as alternative hypotheses both a linear and a non-linear stationary process. For that purpose, we employ three recently developed panel unit-root tests, taking account of structural breaks, cross-section dependence and non-linearities. Contrary to previous studies in the literature, our results reject the pure hysteresis hypothesis and support the characterisation of regional unemployment in Italy as a stationary but non-linear process, subject to multiple equilibria, in line with the ‘structuralist hypothesis’ advanced by Phelps (1994).