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.     

International comovements in inflation rates and country characteristics

Common shocks, similarities in central bank reaction functions, and international trade potentially produce common components in international inflation rates. This paper characterizes such links in international inflation rates with a dynamic latent factor model that decomposes 64 national inflation rates into world, regional, and idiosyncratic components. The world and regional components account for 35% and 16%, respectively, of annual inflation variability on average across countries, so that international influences together explain just over half of inflation variability. The importance of the world and regional components, however, differs substantially across countries. Economic policy choices and development measures strongly explain the cross-sectional variation in the relative importance of international influences. A subsample analysis reveals that the regional (world) factor increases in importance for a number of North American and European (Latin American and Asian) countries since 1980.     

Convergence of Euro area inflation rates

We study the behavior of inflation rates among the 12 initial Euro countries in order to test whether and when the group convergence initially dictated by the Maastricht treaty and now by the ECB, occurs. We also assess the impact of events such as the advent of the Euro and the 2008 financial crisis. Due to the small size of the estimation sample, we propose a new procedure that increases the power of panel unit root tests when used to study group-wise convergence. Applying this new procedure to Euro area inflation, we find strong and lasting evidence of convergence among the inflation rates soon after the implementation of the Maastricht treaty and a dramatic decrease in the persistence of the differential after the occurrence of the single currency. After the 2008 crisis, Euro area inflation rates follow the ECB's price stability benchmark, although Greece reports relatively higher inflation.     

The cointegration relationships among G-7 foreign exchange rates

A search method is applied to foreign exchange rates of G-7 countries, in terms of the US dollar, to estimate cointegration relationships. The method searches numerically, by strictly following the definition of the cointegration, a particular linear combination of nonstationary series in order to make it a stationary series. The list of those exchange rates which are cointegrated from the new method is very different from those derived from the conventional maximum likelihood estimation or ordinary least squares methods. The new method also provides confidence intervals for cointegration coefficients. From the confidence intervals, it is determined that certain G-7 currencies expressed in terms of the mark or the pound become stationary.     

Business cycles in emerging economies: the role of interest rates

We find that in a sample of emerging economies business cycles are more volatile than in developed ones, real interest rates are countercyclical and lead the cycle, consumption is more volatile than output and net exports are strongly countercyclical. We present a model of a small open economy, where the real interest rate is decomposed in an international rate and a country risk component. Country risk is affected by fundamental shocks but, through the presence of working capital, also amplifies the effects of those shocks. The model generates business cycles consistent with Argentine data. Eliminating country risk lowers Argentine output volatility by 27% while stabilizing international rates lowers it by less than 3%.     

Structural Error Correction Models: A System Method for Linear Rational Expectations Models and an Application to an Exchange Rate Model

This paper develops a system instrumental variable method to estimate the speed of adjustment coefficient in the long-run equilibrium of structural error correction models for a class of linear rational expectations models. This method is applied to an exchange rate model with sticky prices, in which the speed of adjustment coefficient governs the half-life of the real exchange rate. Compared to single equation methods, the system method gives smaller half-life estimates with sharper standard errors.     

What causes exchange rate volatility? Evidence from selected EMU members and candidates for EMU membership countries

We allow for monetary, real, and financial variables to assess the relevant importance of each of the variables to exchange rate volatility in the case of selected EMU members and candidate countries. Ex-ante analysis shows that volatility in the Polish zloty/euro and the Hungarian forint/euro forex markets can be influenced by the monetary-side of the economy. On the other hand, ex-post analysis shows that forex markets in France, Italy and Spain had been influenced, during the pre-EMU era, by monetary and real shocks. However, the Irish pound exchange rate per ECU had been affected by only real shocks.     

Comparing New Keynesian models of the business cycle: A Bayesian approach

The baseline New Keynesian model cannot replicate the observed persistence in inflation, output, and real wages for sensible parameter values. As a result, several extensions have been suggested to improve its fit to the data. We use a Bayesian approach to estimate and compare the baseline sticky price model of Calvo's [1983. Staggered prices in a utility maximizing framework. Journal of Monetary Economics 12, 383-398.] and three extensions. Our empirical results are as follows. First, we find that adding price indexation improves the fit of Calvo's [1983. Staggered prices in a utility maximizing framework. Journal of Monetary Economics 12, 383-398.] model. Second, models with both staggered price and wage setting dominate models with only price rigidities. Third, introducing wage indexation does not significantly improve the fit. Fourth, all model estimates suggest a high degree of price stickiness. Fifth, the estimates of labor supply elasticity are higher in models with both staggered price and wage contracts. Finally, the estimated inflation parameters of the Taylor rule are stable across models.     

Business cycles with staggered prices and international trade in intermediate inputs

International trade in intermediate inputs and, increasingly, in goods produced at multiple stages of processing has been widely studied in the real trade literature. We assess the role of this feature of modern world trade in accounting for some stylized facts about international business cycles. Our model with staggered prices and trade in intermediates across four stages of processing does well in explaining the observed international correlations in aggregate quantities, and it performs much better than a single-stage model with no trade in intermediates. The model in itself does not provide a full account of the cyclical behavior of the real exchange rate, but, compared to the single-stage model, it moves in the right direction.     

Regionality revisited: An examination of the direction of spread of currency crises

What determines the direction of spread of currency crises? We examine data on waves of currency crises in 1992, 1994, 1997, and 1998 to evaluate several hypotheses on the determinants of contagion. We simultaneously consider trade competition, financial links, and institutional similarity to the “ground zero” country as potential drivers of contagion. To overcome data limitations and account for model uncertainty, we utilize Bayesian methodologies hitherto unused in the empirical literature on contagion. In particular, we use the Bayesian averaging of binary models that allows us to take into account the uncertainty regarding the appropriate set of regressors.We find that institutional similarity to the ground zero country plays an important role in determining the direction of contagion in all the emerging market currency crises in our dataset. We thus provide persuasive evidence in favour of the “wake-up call” hypothesis for financial contagion. Trade and financial links may also play a role in determining the direction of contagion, but their importance varies amongst the crisis periods.     

The high-frequency response of exchange rates to monetary policy actions and statements

This paper investigates the impact of US monetary policy on the level and volatility of exchange rates using an event study with intraday data for five currencies (the US dollar exchange rate versus the euro, the Canadian dollar, the British pound, the Swiss franc, and the Japanese yen). I construct two indicators of news about monetary policy stemming separately from policy decisions and from balance of risk statements. Estimation results show that both policy decisions and communication have economically large and highly significant effects on the exchange rates, with the surprise component of statements accounting for most of the explainable variation in exchange rate returns in response to monetary policy. This paper also shows that exchange rates tend to absorb FOMC monetary surprises within 30-40 min from the announcement release.     

What Makes the Output–Inflation Trade‐Off Change? The Absence of Accelerating Deflation in Japan

It is standard to model the output–inflation trade-off as a linear relationship with a time-invariant slope. We assess empirical evidence for two sets of theories that allow for endogenous variation in the slope of the short-run Phillips curve. At an empirical level, we examine why large negative output gaps in Japan in the late 1990s did not lead to accelerating deflation but instead coincided with stable, albeit moderately negative inflation. Our results suggest that this episode is most convincingly interpreted as reflecting a gradual flattening of the Phillips curve. We find that this flattening is best explained by models with endogenous price durations. These models imply that in any economy where trend inflation is substantially lower (or substantially higher) today than in past decades, time variation in the slope of the Phillips curve has become too important to ignore.     

Chronicle of currency collapses: Re examining the effects on output

The impact of currency collapses (i.e. large nominal depreciations or devaluations) on real output remains unsettled in the empirical macroeconomic literature. This paper provides new empirical evidence on this relationship using a dataset for 108 emerging and developing economies over the period 1960–2006. We provide estimates of how these episodes affect growth and output trend. Our main finding is that currency collapses are associated with a permanent output loss relative to trend, which is estimated to range between 2% and 6% of GDP. However, we show that such losses tend to materialize before the drop in the value of the currency, which suggests that the costs of a currency crash largely stem from the factors leading to it. Taken on its own (i.e. ceteris paribus), we find that currency collapses tend to have a positive effect on output. More generally, we also find that the likelihood of a positive growth rate in the year of the collapse is over two times more likely than a contraction, and that positive growth rates in the years that follow such episodes are the norm. Finally, we show that the persistence of the crash matters, i.e. one-time events induce exchange rate and output dynamics that differ from consecutive episodes.     

Estimation of the equilibrium exchange rate: The CHEER approach

The paper presents the results of an investigation where the concept of a steady-state level of the exchange rate is equated with the capital market equilibrium based on the CHEER approach. The empirical analysis concentrates on Poland, because in this case the assessment of the equilibrium exchange rate is of vital importance. The prospect of the Polish currency joining the ERM2 provokes controversies and requires research into the economic consequences of accession to the EMU. The international transmission mechanisms affecting the Polish economy are identified within the VEqCM framework. The calculations indicate that in the last years of the analyzed sample (i.e. up to December 2006) the zloty/euro exchange rate was slightly overvalued, and the steady-state level was found to have been adjusting to the value of 4.1 zlotys.     

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.     

Can a real business cycle model without price and wage stickiness explain UK real exchange rate behaviour?

This paper establishes the ability of a Real Business Cycle model to account for UK real exchange rate behaviour. The model is tested by the method of indirect inference, bootstrapping the errors to generate 95% confidence limits for a time-series representation of the real exchange rate, as well as for various key data moments. The results suggest RBC models can explain real exchange rate movements.     

Flexible inflation targets,forex interventions and exchange rate volatility in emerging countries

Emerging economies with inflation targets (IT) face a dilemma between fulfilling the theoretical conditions of “strict IT”, which imply a fully flexible exchange rate, or applying a “flexible IT”, which entails a de facto managed-floating exchange rate with foreign exchange (forex) interventions to moderate exchange rate volatility. Using a panel data model for 37 countries we find that, although IT lead to higher exchange rate instability than alternative regimes, forex interventions in some IT countries have been more effective to lower volatility than in non-IT countries, which may justify the use of “flexible IT” by policymakers.     

Self-fulfilling expectations and the inflation of the 1970s: Evidence from the Livingston Survey

Using survey data on expectations, we examine whether the response of monetary policy to sudden movements in expected inflation contributed to the persistent high inflation of the 1970s. The evidence suggests that, prior to 1979, the Fed accommodated temporary shocks to expected inflation, which then led to persistent increases in actual inflation. We do not find this behavior in the post-1979 data. Among commonly cited factors, oil and fiscal shocks do not appear to have triggered an increase in expected inflation that eventually resulted in higher actual inflation.     

Unraveling the complex interrelationships between exchange rates and fundamentals

This research investigates the intrinsic characteristics of currency values by fundamentally decomposing investor expectations on 16 currencies. The results on 195 exchange rates over several decades indicate investors perceive countries to be more likely to choose devaluation solutions to BOP problems when inflation is lower and when an alternative drop in real income growth is more “painful”. In addition, empirical support is provided for the hypothesis that forward rates often appear biased because the distributional expectations incorporated into them include, for a country with a current account deficit, a small probability of a large spot decline that does not actually occur in most finite samples.     

Forecasting exchange rates out-of-sample with panel methods and real-time data

This paper evaluates out-of-sample exchange rate forecasting with Purchasing Power Parity (PPP) and Taylor rule fundamentals for 9 OECD countries vis-à-vis the U.S. dollar over the period from 1973:Q1 to 2009:Q1 at short and long horizons. In contrast with previous work, which reports “forecasts” using revised data, I construct a quarterly real-time dataset that incorporates only the information available to market participants when the forecasts were made. Using bootstrapped out-of-sample test statistics, the exchange rate model with Taylor rule fundamentals performs better at the one-quarter horizon and panel estimation is not able to improve its performance. The PPP model, however, forecasts better at the 16-quarter horizon and its performance increases in panel framework. The results are in accord with previous research on PPP and Taylor rule models.