THE HARROD–BALASSA–SAMUELSON HYPOTHESIS: REAL EXCHANGE RATES AND THEIR LONG‐RUN EQUILIBRIUM*

Frictions and perturbations may influence currency values in the short run, but it is generally acknowledged that real‐exchange rates eventually settle toward equilibrium. The puzzle then is how gradually this parity is reached given the fluidity in foreign exchange markets. Persistent differences in the relative productivity of countries—a broad characterization of the Harrod–Balassa–Samuelson hypothesis—may help explain this puzzle. This article introduces methods to estimate equilibrium adjustment paths semiparametrically, and then sort how each of these components influences the dynamics of exchange rates. This is done in a dynamic panel setting by introducing novel local projections methods for cointegrated systems. Productivity shocks affect dynamics, and after adjusting for these factors, adjustment toward equilibrium is relatively rapid.     

Persistent misalignments of the European exchange rates: some evidence from non-linear cointegration

The asymmetric and persistent adjustment of the European real exchange rates is investigated using the framework of non-linear cointegration. The episodes of slow mean-reversion dynamics over the period from 1979 to 1999 are explained. A test of unit root against STAR cointegration is proposed and some complete estimations and stochastic simulations of ESTAR models are presented. The presence of effective non-linear adjustment during the moving of the currencies to their long-run fundamental equilibrium exchange rate value is discussed.     

The Real Exchange Rate Always Floats

This paper makes two main points. First, irrespective of nominal exchange rate arrangements, the real exchange rate always floats — if not through nominal exchange rate adjustment, then through price change. Further, because prices and wages tend to be sticky, the adjustment of real exchange rates towards long–run equilibrium takes time, as witnessed by long–lasting currency misalignments around the world. In second place, real exchange rates are rather likely to fluctuate on their way towards long–run equilibrium because of the dynamic interaction between real exchange rates and the current account or, put differently, because the structure of lags with which exchange rates impact the volume of exports and imports may give rise to oscillatory behaviour.     

Long-run versus short-run behaviour of the real exchange rates

This paper discusses the mean stationarity of real exchange rates by using new time series methods and new tests. The question whether the real exchange rates have a unit root or are level reverting is set in the general and flexible framework of fractionally integrated processes. The estimations and tests sustain the claim that real exchange rates may be nonstationary and not revert to any short-run parity. However, estimations also suggest that real exchange rates behave differently on the short and on the long run and that they may revert to parity in a century-long period.     

FEER for the CFA franc

We investigate the behaviour of the real effective exchange rates (REER) of the two CFA franc zone monetary unions?–?CEMAC and WAEMU?–?vis-à-vis their long-run equilibrium paths. A reduced form of the Edwards’ (1989) fundamentals equilibrium exchange rate (FEER) model is estimated using the Johansen's (1995) cointegration methodology, and equilibrium paths and associated misalignments are derived for the period 1970 to 2005. Our results suggest that, for both CEMAC and WAEMU, the fundamentals account for most of the exchange rates’ fluctuation: increases in the terms-of-trade, government consumption and productivity tend to appreciate the exchange rate, while increases in investment and openness tend to depreciate it. At end of 2005, we find no evidence that either the CEMAC or WAEMU REERs were significantly over-valued, which suggests that no exchange rate action is currently needed. Our analysis also reveals significant differences in the fundamentals’ marginal impact, and speed of reversion to equilibrium following a shock, which may raise questions about the desirability of maintaining the same parity for both monetary unions.     

A structural model of price and exchange rate dynamics in a small open economy

Conclusions A major result following from the analysis of ourstructural model of inflation under flexible exchange rates is that there is no such thing asstructural inflation in the long run. Long-run inflation rather becomes a purely monetary phenomenon if exchange rates are flexible and if on an international level functioning capital markets are postulated. While, in the light of the assumptions made in Part III, this finding is not nearly as paradoxical as it may appear at first sight, it can hardly be overemphasized considering the ongoing theoretical discussion and the empirical research on the Scandinavian approach to inflation and recalling that the Scandinavian model is basically intended to picture equilibrium dynamics.The results concerning equilibrium price and exchange rate dynamics also apply to the equilibriumlevels of prices and the exchange rate, i. e., the equilibrium price level depends exclusively on monetary factors while the equilibrium exchange rate is determined by a purchasing power parity element and the structural productivity gap component.Turning to the results of our analysis of disequilibrium dynamics, the overall picture does not change very much. Here the qualitative pattern of adjustment of both prices and the exchange rate is again completely independent of structural variables, but is exclusively determined by four adjustment coefficients. However, the particular quantitative values assumed by prices and the exchange rate during the adjustment process do indeed reflect the impact of the productivity gap.No conclusions can be derived from our model on the amount of time it takes to return to the neighbourhood of equilibrium once the economy has been subjected to some kind of external shock. A casual examination of post-1973 developments and especially the Swiss experience suggest, however, that in the case of a disturbance as, e. g., in the form of a monetary contraction (relative to the rest of the world), the economy may take so long to return to the neighbourhood of long-run equilibrium that the negative real consequences of the overvaluation of the domestic currency during the adjustment process provide a momentous rationale for short-run stabilization interventions in the foreign exchange market.We should like to thank Peter Bernholz and an anonymous referee for helpful comments on a previous version of this paper.     

Real Convergence,Capital Flows,and Competitiveness in Central and Eastern Europe

The paper scrutinizes the role of capital flows for competitiveness in the new EU member states in the context of real convergence. For this purpose it extends the seminal Balassa–Samuelson model by international capital markets to trace cyclical deviations of real exchange rates from the productivity‐driven equilibrium path. Panel estimations for the period from 1998 to 2009 reveal strong evidence for the Balassa–Samuelson effect and mixed results for the role of capital flows for international competitiveness of the Central and Eastern European countries.     

Foreign exchange market interventions and the $–¥ exchange rate in the long run

This article examines whether foreign exchange market interventions conducted by the Bank of Japan are important for the dollar–yen exchange rate in the long run. We rely on a re-examination of the empirical performance of a monetary exchange rate model. This is basically not a new topic; however, we focus on two new questions. First, does the consideration of periods of massive interventions in the foreign exchange market uncover a potential long-run relationship between the exchange rate and its fundamentals? Second, do Forex interventions support the adjustment towards a long-run equilibrium value? Our results suggest that taking periods of interventions into account within a monetary model does improve the goodness of fit of an identified long-run relationship to a significant degree. Furthermore, Forex interventions increase the speed of adjustment towards long-run equilibrium in some periods, particularly in periods of coordinated forex interventions. Our results indicate that only coordinated interventions seem to stabilize the dollar–yen exchange rate in a long-run perspective.     

Disorderly adjustments to the misalignments in the Korean won

This paper estimates the equilibrium exchange rates for Korea'sreal effective rates using Clark and MacDonald's (1999) behaviouralequilibrium exchange rate (BEER) approach. The estimation resultsuggests that the real exchange rate was substantially overvaluedduring the period prior to the currency crisis of 1997–98.The subsequent adjustment, however, was disorderly in the sensethat the real exchange rate overshot its long-run equilibriumvalue. There was also a large deviation from the BEER, indicatingthat the sharp depreciation was not an equilibrium phenomenon.     

ROBUST ESTIMATIONS OF EQUILIBRIUM EXCHANGE RATES WITHIN THE G20: A PANEL BEER APPROACH

This paper is concerned with the robustness of equilibrium exchange rate estimations based on the BEER approach for a set of both industrial and emerging countries. The robustness is studied in four directions, successively. First, we investigate the impact of using alternative proxies for relative productivity. Second, we analyze the impact of estimating the equilibrium equation on one single panel covering G20 countries, or separately for G7 and non-G7 countries. Third, we measure the influence of the choice of the numeraire on the derivation of bilateral equilibrium rates. Finally, we study the temporal robustness of the estimations by dropping one or 2 years from the estimation period. Our main conclusion is that BEER estimations are quite robust to these successive tests, although at one point of time misalignments can differ by several percentage points depending on the methodology. The choice of the productivity proxy is the most sensible one, followed by the country sample. In contrast, the choice of the numeraire and the time sample have a relatively limited impact on estimated misalignments.     

Price dynamics in an exchange economy

The pure exchange model is the foundation of the neoclassical theory of value, yet equilibrium predictions and price adjustment dynamics for this model remained untested prior to the experiment reported in this paper. With the exchange economy replicated several times, prices and allocations in most experiment sessions adjust toward the competitive equilibrium in continuous double auction trading, though adjustment is much slower than in previous commodity flow (or perishable good) double auction market experiments. Price adjustment is evaluated by comparing its extent within each market replication (or trading period) to its extent across trading periods. More price adjustment occurs within trading periods than across trading periods, so price adjustment data are evaluated with the disequilibrium Hahn process model (Hahn and Negishi in Econometrica 30:463–469, 1962) of within-period trades. This paper introduces a stochastic version the Hahn process model and demonstrates that a linear approximation to this stochastic model yields an autoregressive process with a near unit root when the adjustment rate is low. In effect, the autoregressive price adjustment model studied extensively by time series econometricians over the past 30 years can be viewed as a reduced form of a stochastic disequilibrium exchange economy price adjustment model. Estimation of the model demonstrates that price adjustment in the exchange economy experiment is considerably slower than in economies without income effects, which suggests that the price discovery process may be a significant factor in the slow adjustment documented by applied econometricians.     

Reassessing the evidence of an emerging yen block in North and Southeast Asia

Using weekly observations on 9 Asian currencies from November 1976 to December 2003, we re-examine the evidence of an emerging yen block in North and Southeast Asia. In contrast to previous research that assumes instantaneous adjustment of exchange rates by the region's Central Banks to variations in the world's main global currencies, we use a dynamic general-to-specific Newey–West estimation strategy that allows gradual adjustment and calculation of both short and long run equilibrium responses. We find that there is no de facto yen block, but although the US dollar remains dominant throughout the region, the yen's influence is rising amongst a subset of the currencies since the early 1990s.     

Trade flows,relative prices,and effective exchange rates: a VAR on Ethiopian data

The dynamic response of trade flows to price and effective exchange rate changes is examined via VAR using quarerly data from Ethiopia for the period 1973(i)–1985(iv). The results show one-way Granger-causality running from prices and exchange rates to imports and exports without significant feedback. Imports and exports exhibit similar response patterns to unexpected changes in relative prices and exchange rates. The responses of imports and exports are larger and the adjustment takes longer when relative prices rather than exchange rates caused a change in international prices. In the long-run, changes in prices account for a larger percentage of the forecast error variances in imports and exports than exchange rate changes. It is shown that devaluation may have an initial adverse effect on the trade balance.     

Seasonal fluctuations and equilibrium models of exchange rate

Most of the evidence on dynamic equilibrium exchange rate models is based on seasonally adjusted consumption data. Equilibrium models have not worked well in explaining the actual exchange rate. However, the use of seasonally adjusted data might be responsible for the spurious rejection of the model. This article presents a new equilibrium model for the exchange rates that incorporates seasonal preferences. The fit of the model to the data is evaluated for five industrialized countries using seasonally unadjusted data. Our findings indicate that a model with seasonal preferences can generate monthly time series of the exchange rate without seasonality even when the variables that theoretically determine the exchange rate show clear seasonal behaviours. Further, the model can generate theoretical exchange rates with the same order of integration than actual exchange rates, and in some cases, with the same stochastic trend.     

Beyond Balassa and Samuelson: real convergence,capital flows,and competitiveness in Greece

To better understand the convergence process prior and since the European financial and debt crisis, we scrutinize the role of capital flows for competitiveness in Greece and a set of six other euro area member countries (Portugal, Latvia, Estonia, Lithuania, Slovenia and the Slovak Republic). For this purpose the paper extends the seminal Balassa–Samuelson model by international capital markets with a particular focus on their impact on national wage policies. Capital flows are assumed to be able to invert the traditional direction of transmission of real wage increases from the tradable sector to the non-tradable sector and to make real wages increase beyond productivity increases. The augmented Balassa–Samuelson model is extended to trace cyclical deviations of real exchange rates from the productivity-driven equilibrium path. Panel estimations for the period from 1995 to 2013 reveal correlations in line with the Balassa–Samuelson effect, if Greece is excluded from the panel. For Greece, this in turn implies indication in favour of a credit-driven real wage increases beyond productivity increases what we call a “pseudo” Balassa–Samuelson effect.     

Structural breaks, cointegration, and speed of adjustment Evidence from 12 LDCs money demand

This article estimates a theoretically coherent and empirically robust money demand function for 12 developing countries. The modeling procedure not only tests for a regime shift in the cointegrating equation, but also in the error correction model. Five specific hypotheses are examined. The article demonstrates that a long-run equilibrium relationship exists between real M1 or M2 balances, real income, inflation, exchange rate, foreign exchange risk, and foreign interest rates in the countries studied. The study provides information on the speed of adjustment to equilibrium and the median and mean time lags for adjustment of real money balances to changes in each determinant. Although our results provide more evidence against M1 than M2, this study clearly establishes that both M1 and M2 must be considered as viable policy tools for less developed countries.     

Price Commitment versus Flexibility: the Role of Exchange Rate Uncertainty and its Implications for Exchange Rate Passthrough

The paper investigates the incentives to commit price or retain price flexibility in a model in which exporting firms face different degrees of exchange rate uncertainty. The result shows that introducing exchange rate uncertainty can lead to the endogenous emergence of a unique leader–follower equilibrium; which firm emerges as price leader depends on the substitutability of products, the magnitude of exchange rate uncertainty, and the cost structure. This study may provide one explanation as to why some exporters set price before the realization of the nominal exchange rates (“sticky price”). The results imply exchange rate variability affects exchange rate passthrough.     

Estimating an equilibrium exchange rate for the dollar and other key currencies

In this paper, we adapt the concept of fundamental equilibrium exchange rates ‘FEER’ in a complete model approach. We use it to determine the likely paths of the Dollar and other key currencies. The FEER is the (real) exchange rate that is consistent with internal balance and sustainable external balances. Here we examine the composition of a Dollar adjustment and hence the extent to which a FEER (for the US) depends on factors or rigidities elsewhere in the world, as well as at home. We find, the US still needs to accept an adjustment in her real exchange rate if the increase in her foreign liabilities is to come to an end. However, counterpart adjustments also have to be made in Canada, Mexico, and some Asian economies if this policy is to be successful. We also show that productivity growth differentials may act as a substitute for depreciation, and this provides an explanation for the failure of the dollar to depreciate in the 1990s.     

Integral stabilization policy and flexible exchange rates

Summary Under a floating exchange rate system, exchange rates influence economic activity through their effect on the trade balance. Nevertheless, exchange rate movementsper se do not prevent integral fiscal and monetary policies from achieving a target for domestic economic activity²⁴. At the same time, since the exchange rate continuously moves to preserve asset market equilibrium, the (potential) balance of payments may not be equilibrated when the authorities have attained their internal target. In that event, the continued movement in exchange rates may produce cycles in economic activity which in turn lead to exchange rate oscillations. Finally, the reader is warned that the introduction of inside and outside lags into the system may produce additional oscillatory behavior or even explosiveness, as Phillips demonstrated for the closed economy. However, these new possibilities would arise independently of the floating exchange rate system and could not be attributed to it.     

A Case for Managed Exchange Rates*

The incorporation of adaptive expectations by Dornbusch in a Mundell-Fleming model modifies significantly the traditional results of policy effectiveness in a small, open economy. While monetary policy is still able to influence aggregate demand when flexible exchange rates prevail, the effects of this policy on other important variables in the economy during the adjustment process to a new equilibrium may be considered sufficiently ‘disruptive’ so that the authorities will be hesitant to use their only fully-effective policy instrument for income-stabilization purposes. However, by adding a target level for the exchange rate to their list of goal variables and by using an appropriate mix of monetary and fiscal policies, it appears to be possible for the government to avoid these disruptive side effects.