Forecasting the Euro exchange rate using vector error correction models

Forecasting the Euro Exchange Rate Using Vector Error Correction Models. — This paper presents an exchange rate model for the Euro exchange rates of four major currencies, namely the US dollar, the British pound, the Japanese yen and the Swiss franc. The model is based on the monetary approach of exchange rate theory which uses fundamental macroeconomic variables to explain the exchange rate. A crucial point when using such a model is its proper estimation through cointegration analysis. The euro exchange rate model is therefore estimated in the form of a Vector Autoregressive (VAR) model with cointegrating vectors (VECM). We find that when cointegration analysis is undertaken properly, the naive random walk prediction can be out-performed for the US dollar, the British pound and the Japanese yen, but not for the Swiss franc.     

Net foreign asset positions and appreciation expectations on the Swiss franc and the Japanese Yen

The paper shows that currencies of countries with persistent current account surpluses and high foreign-currency denominated assets, such as the Swiss franc and the Japanese yen, are under persistent appreciation pressure, particularly when the centres of the world monetary system follow expansionary monetary policies. This limits the choice of exchange rate regime. Given flexible exchange rates, a negative risk premium on the domestic interest rate can emerge. Empirical estimations provide mixed evidence for a negative impact of net foreign asset positions and exchange rate uncertainty on interest rates of international creditor countries at the periphery of the world monetary system.     

Testing the Marshall–Lerner Condition in Kenya

In this paper we examine the Marshall–Lerner (ML) condition for the Kenyan economy. In particular, we use quarterly data on the log of real exchange rates, export/import ratio and relative (US) income for the time period 1996q1‐2011q4, and employ techniques based on the concept of long memory or long‐range dependence. Specifically, we use fractional integration and cointegration methods, which are more general than standard approaches based exclusively on integer degrees of differentiation. The results indicate that there exists a well‐defined, cointegrating relationship linking the balance of payments to the real exchange rate and relative income, and that the ML condition is satisfied in the long run, although the convergence process is relatively slow. They also imply that a moderate depreciation of the Kenyan shilling may have a stabilising influence on the balance of trade through the current account without the need for high interest rates.     

Integration of Long-Term Interest Rates: Empirical Evidence for G7 Countries

Abstract

This article investigates the fractional cointegration relationship between long-term interest rates of G7 countries over the period from 1990:01 to 2010:04 by estimating the cointegrating regressions for possible bivariate, trivariate and four-variate subsystems as well as the full system. The obtained results indicate that long-term interest rates are fractionally cointegrated for bivariate subsystems of Canada–France, Canada–Japan and Canada–UK and four-variate subsystem of Canada–USA–France–UK, implying integration.     

Generalized purchasing power parity and the case of the European Union as a successful currency area

This article uses multicountry purchasing power parity (PPP) tests to study the success of the European monetary system (EMS) in creating a successful currency area for a stable European monetary union. If the EMS has sufficiently integrated the fundamentals within the European Union, then real exchange rates between member countries will share a common stationary trend when denominated by a common outside currency. Previous research using two-country PPP tests have been inadequate in explaining the nonstationary nature of real exchange rates between the EMS countries and nonmember countries. The use of generalized PPP tests can show that even though individual exchange rates within the EMS may appear to be nonstationary with respect to outside countries, some of them will combine to form a currency union with a stable stationary trend.     

Business Cycle Synchronisation with(in) the Euro Area: in Search of a ‘Euro Effect’

This paper studies business cycle synchronisation and convergence in the euro area. A set of stylised facts concerning the characteristics of the business cycle and synchronisation in the euro area is derived. It is analysed whether convergence or divergence patterns between the euro area countries changed after the introduction of the euro. In addition, a closer look is taken at the degree of business cycle synchronisation between other, i.e. non-euro area countries and the euro area average. Furthermore, a dynamic correlation analysis is carried out to broaden the scope of business cycle synchronisation further. We enrich the study with a frequency domain analysis and use the concepts of coherence, dynamic correlation and phase. Our main results are (i) that the synchronisation of business cycles in the euro area is fairly high, and (ii) that the introduction of the euro in 1999 does not seem to have generated a very strong—neither positive nor negative—impact on synchronisation. Coherence and dynamic correlation among the euro area countries, the UK, Japan and the US are also fairly high, reminding of the importance of synchronisation with the global business cycle.     

Monetary unions, external shocks and economic performance: A Latin American perspective

During the last few years there has been a renewed analysis in currency unions as a form of monetary arrangement. This new interest has been largely triggered by the Euro experience. Scholars and policy makers have asked about the optimal number of currencies in the world economy. They have analyzed whether different countries satisfy the traditional “optimal currency area” criteria. These include, among other: (a) the synchronization of the business cycle; (b) the degree of factor mobility; and (c) the extent of trade and financial integration. In this paper I analyze the desirability of a monetary union from a Latin American perspective. First, I review the existing literature on the subject. Second, I use a large data set to analyze the evidence on economic performance in currency union countries. I investigate these countries’ performance on four dimensions: (a) whether countries without a national currency have a lower occurrence of “sudden stop” episodes; (b) whether they have a lower occurrence of “current account reversal” episodes; (c) what is their ability to absorb international terms of trade shocks; and (d) what is their ability to absorb “sudden stops” and “current account reversals” shocks. I find that belonging to a currency union has not lower the probability of facing a sudden stop or a current account reversal. I also find that external shocks have been amplified in currency union countries. The degree of amplification is particularly large when compared to flexible exchange rate countries.     

A COMPARATIVE ANALYSIS OF THE SYNCHRONISATION OF BUSINESS CYCLES FOR DEVELOPED AND DEVELOPING ECONOMIES WITH THE WORLD BUSINESS CYCLE

Globalisation brought about worldwide changes, including economic and financial integration between countries. The objective of this paper is to establish if there is synchronisation between developed and developing countries with the world cycle. Research results show that business cycles have become less volatile after globalisation, but there is not much consensus on whether business cycles have become less or more synchronised since globalisation. Little research has been done on co‐movement between emerging markets, such as South Africa, and the world business cycle. This paper derives common factors for developed and developing countries by applying principal component analysis (PCA) to output, consumption and investment data, which represents the countries' business cycles. The empirical analysis shows co‐movement between some countries and the world business cycle (G7 countries as proxy). The results suggest that there are idiosyncratic and globally common shocks, which play different roles over time in different countries. The paper goes on to suggest that there are clear differences in how developed and emerging markets co‐move with the world business cycle. A key finding is that the co‐movement between developing economies and the world business cycle has increased since globalisation. This research also confirms previous research that most economies follow the world business cycle when large shocks – such as the recent economic downturn – occur. This has implications for forecasting the business cycle, especially in times of economic turmoil.     

Switzerland and the euro

Switzerland is not a member of the European Union and, therefore, does not belong to the euro area. Nevertheless, the exchange rate of the Swiss franc against the euro has remained fairly stable. This stability does not imply that the Swiss National Bank pegs the exchange rate to the euro. On the contrary, the Swiss National Bank continues to pursue an autonomous monetary policy since monetary autonomy conveys various benefits to the Swiss economy.     

Dynamic forecasting of sticky-price monetary exchange rate model

The Dornbusch-Frankel monetary model is used to estimate the out-of-sample forecasting performance for the U.S. or Canadian dollar exchange rate. By using Johansen's multivariate cointegration, up to three cointegrating vectors were found between the exchange rate and macroeconomic fundamentals. This means that there is a long-run relationship between exchange rate and economic fundamentals. Based on error-correction models, the random-walk model outperforms the Dornbusch-Frankel model at every forecasting horizon. The random-walk model also dominates the Dornbusch-Frankel model with the modified money demand function at every forecasting horizon except one month. However, this paper shows that the share price variable can improve the accuracy of forecasts of exchange rates at short-run horizons.     

Monetary Union,Trade Integration,and Business Cycles in 19th Century Europe

This paper studies the impact of monetary arrangements on trade integration and business cycle correlation in late 19th century Europe. We estimate a gravity model and show that tighter monetary integration was associated with substantially higher trade, as in recent studies using contemporary data. For instance, the Austro-Hungarian monetary union improved trade between member states by a factor of 3. To explain this, we build and estimate a simple model where greater monetary integration weakens the current account constraint by fostering business cycle co-movements.     

The French commitment to European monetary integration: A review of the two EMS crises (1981–83, 1992–93)

This paper focuses on the process of exchange rate management during the two European Monetary System(EMS) crises, in 1981–83 and 1992–93, and examines the factors which led the French governments to adhere to the EMS. France's strong franc (franc fort) policy is a useful test case for maintaining national commitment to European monetary integration. The origin of the franc fort policy can be traced back to the exchange rate crisis of 1981–83. By actively supporting European institutions and emphasizing the emergence of a strong and united European common currency, France discovered the way to bolster confidence in her economic policy. Beyond this focal point, political justification and economic rationality became mutually reinforcing, configuring French national preference in European monetary integration. The response of the French government to the EMS crisis of 1992–93 was more consistent compared to the response to the 1981–83 crisis, and reflected the accumulation of loyalty to European monetary integration. This loyalty, however, was made neither from purely economic calculation nor out of normative commitment French European monetary policy reflected the interaction between domestic politics and European monetary integration. The French commitment to the franc fort also was based on domestic political bases such as the existence of a core policy group, a centralized policy‐making structure, and an issue linkage between the franc fort and European integration.     

Currency Substitution and the Stability of the Demand for Money in East Asia

Abstract

This paper models and tests the stability of the demand for money in five East Asian countries—Indonesia, Malaysia, Philippines, Singapore, and Thailand—in the context of an open economy. The Johansen multivariate cointegration vector error correction analysis against quarterly data covering the period 1985:1–2001:4 was used. It was found that a stationary long run cointegrating relationship exists between broad money, real income, domestic interest rates, foreign interest rates corrected for exchange rate depreciation, and the expected rate of depreciation of the exchange rate. The results show that US Treasury bills rates and the foreign exchange rate vis-à-vis the US dollar play a significant role in the East Asian countries money demand relationship. This suggests that currency substitution vis-à-vis the US dollar may be an important consideration in the design and implementation of monetary policy in the East Asian countries. Furthermore, the results show that the Asian currency crises impacted the money demand functions negatively in these countries. CUSUM and CUSUMSQ stability tests show no evidence of parameter instability of the money demand functions in three of the five countries throughout the period under investigation.     

Is an Optimum Currency Area Feasible in East and South East Asia?

Abstract

In the backdrop of the recent economic crisis in the European Union, this study attempts to assess the degree of regional integration and the suitability of a monetary union in the East and South-East Asian (ESEA) region. For this purpose, we analyse the issue in a variety of ways. First, a long-run linkage of real output of the countries is tested using the cointegration analysis. Results suggest that real output of most of the countries in the region is cointegrated and move together in the long-run. To analyse the issue in detail, we focus on the impact of three different shocks, namely global, regional and country-specific, on real output of the countries. Results of impulse response and variance decomposition analysis reveal that regional shocks do not dominate in the sample countries, which is an indication of unfavourable condition to form an optimal currency area (OCA) in the region. These results are further confirmed by the outcome of computation of the modified Bayoumi and Eichengreen's Indices. Finally, we employ the concept of Generalized Purchasing Power Parity (G-PPP), which however reveals that the bilateral real exchange rate of ESEA countries move together in the long-run and share a common stochastic trend, which in turn provides some empirical support for an OCA in the region.     

Inflation and Business Cycle Convergence in the Euro Area: Empirical Analysis Using an Unobserved Component Model

The literature on optimum currency areas states that large inflation differentials can undermine monetary union. In the euro area, inflation rates diverged after the creation of the single currency, but started to converge again from mid-2002. Against this background, we assess the convergence of inflation rates and business cycles and study the relationship between them. The analysis is made using an unobserved component model estimated with the Kalman filter. In general, from 1980 to 2008 inflation rates and business cycles became more aligned in the euro area, but inflation rates converged more quickly than business cycles. The output gap is found to be a better indicator of the business cycle than unit labour cost when studying convergence. By looking at the causality between the convergence of inflation and output gap, it is found that inflation divergence has a limited destabilising economic impact.     

Business Cycle Synchronisation: Disentangling Trade and Financial Linkages

Drawing on a large cross-section of countries, this paper explores whether closer economic ties between countries foster business cycle synchronisation and disentangles the role of the various channels, including trade and financial linkages as well as the similarity in sectoral specialisation. Our results confirm that output comovement is higher for country pairs with closer trade linkages and similar patterns of sectoral specialisation. By contrast, it remains difficult to find a direct relationship between bilateral financial linkages and output correlation. However, our results suggest that financial integration spurs business cycle synchronisation indirectly by raising the similarity in sectoral specialisation. Notably, the main findings hold regardless of whether financial linkages are captured in terms of FDI or portfolio holdings.     

Business cycle transmission and interdependence between Japan and Australia

This paper investigates business cycle transmission and interdependence between Australia and Japan over the period 1961.1–1994.4. Vector autoregression (VAR) and vector error correction (VEC) models were constructed utilizing GDP/GNPs, producer prices, interest rates and money supplies. The model is tested for cointegration. Two cointegrating vectors are found, and a vector error correction (VEC) model is estimated. The coefficients and the F-tests of the VEC are used to measure the effect of one economy upon the other. Impulse responses from a VAR are examined for evidence of business cycle transmission, and recursive least squares estimates are used to check for structural change in the relationship. Figures are used to graphically demonstrate these relationships and have been collected in an appendix, which can be found at the end of the text.While the two countries engage in a close trading relationship, the two economies are found to be only somewhat interdependent in macroeconometric terms. Japan is found to transmit some of its business cycle fluctuations to Australia, but there is little reverse transmission.     

One Money and Sixteen Needs: Has the ECB’s Monetary Policy Become More Balanced Towards the Needs of the Member States?

In this paper we analyze whether the ECB’s monetary policy has become more balanced towards the needs of the individual member states with the passage of time. We assume that the ECB’s monetary policy stance is in line with a Taylor rule and based on the overall situation in the Euro area, more specifically on the Euro area inflation rate and the overall business cycle position in the area. The question therefore boils down to investigating whether inflation and business cycles have converged since the start of the monetary union. We show that the ECB, if in existence in the 1990s, would have had an impossible task. This is because inflation and business cycles still strongly differed in that time, although convergence substantially increased in the run up to the monetary union. In this respect, the decade under EMU drastically differs from the preceding one. This being said, the evidence for a further improvement in the course of the first decade of the new millennium is mixed. This is because although inflation has further converged, business cycles have shown a tendency for increased divergence. If, however, we are willing to put weights on inflation and output gap divergence (as implied by the Taylor rule), we conclude that also in the course of the period under EMU in general the ECB’s monetary policy has become more in line with the needs of the individual members. Looking at individual countries, we show that during the first decade of its existence the ECB’s interest rate was most fitted to the needs of France and Italy, and least to the needs of Ireland and Greece (both too low) and Germany (too high). To a lesser extent there were also mismatches for Spain and Portugal (both too low). In the more recent period since 2005, the mismatch between the desired domestic interest rate and the desired ECB rate has come down for most countries (most noticeable Germany). For Belgium (for which a higher interest rate was more appropriate), on the other hand, the mismatch increased. These overall positive findings, however, offer no guarantee that the task of the ECB will become easier in the future.