On the sensitivity of the volume and volatility of bilateral trade flows to exchange rate uncertainty

We present an empirical investigation of the hypotheses that exchange rate uncertainty may have an impact on both the volume and variability of trade flows by considering a broad set of industrial countries' bilateral real trade flows over the period 1980–1998. Similar to the findings of earlier theoretical and empirical research, our first set of results shows that the impact of exchange rate uncertainty on trade flows is indeterminate. Our second set of results provides new and novel findings that exchange rate uncertainty has a consistent positive and significant effect on the volatility of bilateral trade flows, helping us better understand macroeconomic volatility.     

Short-run forecasting of the euro-dollar exchange rate with economic fundamentals

We propose a fundamentals-based econometric model for the weekly changes in the euro-dollar rate with the distinctive feature of mixing economic variables quoted at different frequencies. The model obtains good in-sample fit and, more importantly, encouraging out-of-sample forecasting results at horizons ranging from one-week to one month. Specifically, we obtain statistically significant improvements upon the hard-to-beat random-walk model using traditional statistical measures of forecasting error at all horizons. Moreover, our model obtains a great improvement when we use the direction of change metric, which has more economic relevance than other loss measures. With this measure, our model performs much better at all forecasting horizons than a naive model that predicts the exchange rate as an equal chance to go up or down, with statistically significant improvements.     

Mean and volatility dynamics of Indian rupee/US dollar exchange rate series: an empirical investigation

The paper is concerned with time series modelling of foreign exchange rate of an important emerging economy, viz., India, with due consideration to possible sources of misspecification of the conditional mean like serial correlation, parameter instability, omitted time series variables and nonlinear dependences. Since structural change is pervasive in economic time series relationships, the paper first studies this aspect of the exchange rate series in detail and finds the existence of four structural breaks. Accordingly, the entire sample period is divided into five sub-periods of stable parameters each, and then the appropriate mean specification for each of these sub-periods is determined by incorporating functions of recursive residuals. Thereafter, the GARCH and EGARCH models are considered to capture the volatility contained in the data. The estimated models thus obtained suggest that return on Indian exchange rate series is marked by instabilities and that the appropriate volatility model is EGARCH. Further, out-of-sample forecasting performance of the model has been studied by standard forecasting criteria, and then compared with that of an AR model only to find that the findings are quite favorable for the former.      

The high-frequency response of exchange rates and interest rates to macroeconomic announcements

The joint movements of exchange rates and U.S. and foreign term structures over short-time windows around macro announcements are studied using a 14-year span of high-frequency data. In order to evaluate whether the joint effects can be reconciled with conventional theory, the implications of these joint movements for changes in expected future exchange rates and changes in foreign exchange risk premia are deduced. For several real macro announcements, a stronger than expected release appreciates the dollar today, and must either (i) lower the risk premium for holding foreign currency rather than dollars, or (ii) imply net expected dollar depreciation over the ensuing decade.     

Expectations of future income and real exchange rate movements

We show that changes in expectations of future income driven by exogenous factors (such as the discovery of oil and an increase in global demand for natural resources) can cause movements in the real exchange rate (RER) in excess of, and sometimes even in the opposite direction to, what one would expect given the changes in current income. We provide both a theoretical model and empirical evidence of this. In particular, we show that the signing of numerous production sharing agreements (PSAs) between the government of Azerbaijan and foreign oil companies in 1994–1998 fueled expectations of higher future incomes, resulting in a considerable appreciation of the RER. Some of these PSAs subsequently failed or ran into difficulties, which led to a downward revision of expected future income and a depreciation of the RER in 1999–2003, even though the current income started to rise, due to an increase in the current oil revenue.     

Nonlinear exchange rate predictability

We study whether the nonlinear behavior of the real exchange rate can help us account for the lack of predictability of the nominal exchange rate. We construct a smooth nonlinear error-correction model that allows us to test the hypotheses of nonlinear predictability of the nominal exchange rate and nonlinear behavior on the real exchange rate in the context of a fully specified cointegrated system. Using a panel of 19 countries and three numeraires, we find evidence of nonlinear predictability of the nominal exchange rate and of nonlinear mean reversion of the real exchange rate. Out-of-sample Theil’s U -statistics show a higher forecast precision of the nonlinear model than the one obtained with a random walk specification. Although the robustness of the out-of-sample results over different forecast windows is somewhat limited, we are able to obtain significant predictability gains—from a parsimonious structural model with PPP fundamentals—even at short-run horizons.     

Productivity shocks and real exchange rates

Previous studies have concluded that productivity shocks have negligible effects on real exchange rate fluctuations. This paper shows that when long-run equilibrium relationships between real exchange rate levels and fundamental variables are taken into account, relative productivity shocks account for most of the long-run movements in the real exchange rates. This can be interpreted as empirical support for the Balassa (1964. Journal of Political Economy 72, 584-596) and Samuelson (1964. Review of Economics and Statistics 46, 145-154) model where differences in relative productivity is the main source of long-run deviations for purchasing power parity.     

Real exchange rate adjustment in European transition countries

In single-equation tests, real exchange rates show mean reversion for nine of 10 Central and Eastern European transition countries for the period January 1993 to December 2005. Because of the shift from controlled to market economies and accompanying crises, failed policy regimes and changes in exchange rate regimes, unit root tests for transition countries often require allowance for structural changes. Accounting for structural breaks gives substantially faster mean-reversion speeds than those found for major industrialized countries. These fast adjustment speeds are plausible: Transition countries had perhaps 10 years to make unprecedented adjustments required for accession to the European Union. A number of papers have applied non-linear models to the Central and Eastern European countries. This paper investigates four non-linear models and compares them with piece-wise linear break models. The break models appear superior in detecting mean reversion for the Central and Eastern European transition countries.     

Real exchange rate behavior

Using random simulations with artificial data with identical sample characteristics to the long-sample exchange rate data employed by Lothian and Taylor (Lothian, J.R. and Taylor, M.P. (1996). The recent float from the perspective of the past two centuries. Journal of Political Economy 104, 488–509.), we show that standard unit-root tests have extremely low power over sample sizes corresponding to the recent float. The probability of rejecting the null hypothesis when it is false is extremely low with 20 years or even 50 years of data and only reaches an acceptable level over much longer spans.     

Adjustment patterns to commodity terms of trade shocks: The role of exchange rate and international reserves policies

We analyze the way in which Latin American countries have adjusted to commodity terms of trade (CTOT) shocks in the 1970–2007 period. Specifically, we investigate the degree to which the active management of international reserves and exchange rates impacted the transmission of international price shocks to real exchange rates. We find that active reserve management not only lowers the short run impact of CTOT shocks significantly, but also affects the long run adjustment of REER, effectively lowering its volatility. We also show that relatively small increases in the average holdings of reserves by Latin American economies (to levels still well below other emerging regions current averages) would provide a policy tool as effective as a fixed exchange rate regime in insulating the economy from CTOT shocks. Reserve management could be an effective alternative to fiscal or currency policies for relatively trade closed countries and economies with relatively poor institutions or high government debt. Finally, we analyze the effects of active use of reserve accumulation aimed at smoothing REERs. The result support the view that “leaning against the wind” is potent, but more effective when intervening to support weak currencies rather than intervening to slow down the pace of real appreciation. The active reserve management reduces substantially REER volatility.     

The random-walk behavior of the Euro exchange rate

We use Generalized Andrews–Ploberger (GAP) tests to examine the random-walk behavior of 17 OECD countries’ euro exchange rates at daily frequencies. The GAP tests reject the hypothesis of random-walk behavior less often than do traditional tests. Moreover, the random-walk hypothesis cannot be rejected for the euro’s exchange rate against most of the major currencies. We also use the generalized Box–Pierce tests to produce evidence that corroborates the above findings. Finally, and in contrast to the traditional tests, the GAP tests produce results that are consistent during the great moderation and the recent global financial crisis periods.     

Economic convergence and the fundamental equilibrium exchange rate in central and eastern Europe

The paper presents an extended version of the fundamental equilibrium exchange rate model (FEER), which introduces potential output into foreign trade equations. We show that with this specification and under some plausible assumptions the equilibrium exchange rate is consistent with the behavioral equilibrium exchange model (BEER). We use the extended FEER model to analyze fluctuations of the real exchange rate in four central and eastern European countries. The resulting FEER calculations show that the appreciation of the real exchange rates in these countries in the past nine years is largely an equilibrium phenomenon.     

Modeling exchange rate passthrough after large devaluations

Large devaluations are generally associated with large declines in real exchange rates. We develop a model which embodies two complementary forces that account for the large declines in the real exchange rate that occur in the aftermath of large devaluations. The first force is sticky nontradable-goods prices. The second force is the impact of real shocks that often accompany large devaluations. We argue that sticky nontradable goods prices generally play an important role in explaining post-devaluation movements in real exchange rates. However, real shocks can sometimes be primary drivers of real exchange-rate movements.     

Home bias,exchange rate disconnect,and optimal exchange rate policy

This paper examines how much the central bank should adjust the interest rate in response to real exchange rate fluctuations. The paper first demonstrates, in a two-country Dynamic Stochastic General Equilibrium (DSGE) model, that home bias in consumption is important to replicate the exchange rate volatility and exchange rate disconnect documented in the data. When home bias is high, the shock to Uncovered Interest rate Parity (UIP) can substantially drive up exchange rate volatility while leaving the volatility of real macroeconomic variables, such as GDP, almost untouched. The model predicts that the volatility of the real exchange rate relative to that of GDP increases with the extent of home bias. This relation is supported by the data. A second-order accurate solution method is employed to find the optimal operational monetary policy rule. Our model suggests that the monetary authority should not seek to vigorously stabilize exchange rate fluctuations. In particular, when the central bank does not take a strong stance against the inflation rate, exchange rate stabilization may induce substantial welfare loss. The model does not detect welfare gain from international monetary cooperation, which extends Obstfeld and Rogoff's [Obstfeld, M., Rogoff, K.,2002. Global implications of self-oriented national monetary rules, Quarterly Journal of Economics May, 503–535] findings to a DSGE model.     

Macroeconomic sources of foreign exchange risk in new EU members

We address the issue of foreign exchange risk and its macroeconomic determinants in several new EU members. We derive the observable macroeconomic factors—consumption and inflation—using the stochastic discount factor (SDF) approach. The joint distribution of excess returns in the foreign exchange market and the factors are modeled using a multivariate GARCH-in-mean specification. Our findings show that both real and nominal factors play important roles in explaining the variability of the foreign exchange risk premium. Both types of factors should be included in monetary general equilibrium models employed to study excess returns. To contribute to the further stability of domestic currencies, the new EU members should strive to implement stabilization policies aimed at achieving nominal as well as real convergence with the core EU members.     

A portfolio balance approach to the Canadian-U.S. exchange rate

An empirical portfolio balance model based on Branson and Henderson [Branson, W. H., & Henderson, D. W. (1985). The specification and influence of assets markets. In: Jones R. W., Kenen, P. B. (Eds.), Handbook of International Economics, Volume 2, Elsevier, Amsterdam] is specified for the Canadian-U.S. exchange rate over the floating exchange rate period. Empirical implementation reveals two cointegrating vectors that closely, although not perfectly, match the home and foreign asset demands of the theoretical model. Furthermore, the exchange rate is important in the error correction process. Finally, although the significance is quantitatively and statistically modest, a simplified version of the empirical model resulting from general-to-specific procedures is able to beat a random walk at some out-of-sample forecast horizons.     

A twelve-area model for the equilibrium Chinese Yuan/US dollar nominal exchange rate

This paper investigates the equilibrium CNY/USD nominal exchange rate during 1976-2008. We extend for the first time the five-area FABEER model to a twelve-area TABEER model for China. All parameters are estimated with allowance for endogenous structural breaks. Our investigation of the sustainable current account highlights macroeconomic factors that determine savings and investment in the medium-term. We find that all cointegration relationships are subject to structural breaks. The equilibrium nominal rate was overvalued in most years from early 1990s until 2003. It has been strongly undervalued during 2004-2008. We further compute misalignment rates using a sustainable current account of 3%. Our findings suggest such exogenous input leads to results biased towards larger undervaluation.     

How well does nonlinear mean reversion solve the PPP puzzle?

This paper addresses the degree to which models which exhibit nonlinear mean reversion (NMR) present a resolution to the Purchasing Power Parity Puzzle. This paper develops a method of estimating a representative distribution of half lives which is based upon the observed distribution of shocks in a given time series rather than choosing shock sizes arbitrarily which is the current practice in the literature. This approach is implemented with data on five real exchange rates. The empirical analysis shows that half lives shorter than the consensus are observed frequently enough to support the proposition that NMR is a solution to the PPP puzzle.     

Temporal aggregation and purchasing power parity persistence

This paper uses a unique new monthly US-UK real exchange rate series for the January 1794-December 2009 period to reexamine the academic debate over purchasing power parity (PPP). The consensus view described by Rogoff (1996) is that PPP holds in the long-run, but short-run deviations are very persistent, with half-lives ranging from 3 to 5 years. Most of the literature using long time series relies on the annual data developed by Lee (1976) and Lothian and Taylor (1996), which were both constructed from underlying higher-frequency data sources. Estimates of purchasing power parity persistence using these series may therefore be subject to temporal aggregation bias. We find evidence of aggregation bias which indicates the half-life of PPP deviations has been overestimated in much of the previous literature. We also find that estimates of the half-lives are further reduced once we account for the Harrod (1933)-Balassa (1964)-Samuelson (1964) effect. The result of aggregation bias appears to be robust even when considering the case that real exchange rates exhibit nonlinear dynamics.     

A century of purchasing power parity confirmed: The role of nonlinearity

Taylor (2002) claims that Purchasing Power Parity (PPP) has held over the 20th century based on strong evidence of stationary for century-long real exchange rates for 20 countries. Lopez et al. (2005), however, found much weaker evidence of PPP with alternative lag selection methods. We reevaluate Taylor’s claim by implementing a recently developed nonlinear unit root test by Park and Shintani (2005). We find strong evidence of nonlinear mean-reversion in real exchange rates that confirms Taylor’s claim. We also find a possible misspecification problem in using the ESTAR model that may not be detected with Taylor-approximation based tests.