nep-ifn New Economics Papers
on International Finance
Issue of 2005‒10‒04
thirty-six papers chosen by
Yi-Nung Yang
Chung Yuan Christian University

  1. Do Dollar Forecasters Believe too Much in PPP? By Menkhoff, Lukas; Rebitzky, Rafael; Schröder, Michael
  2. Target Zones in Theory and History: Credibility, Efficiency, and Policy Autonomy By Flandreau, Marc; Komlos, John
  3. Exchange rates and fundamentals - new evidence from real-time data By Michael Ehrmann; Marcel Fratzscher
  4. An empirical study of liquidity and information effects of order flow on exchange rates By Francis Breedon; Paolo Vitale
  5. Exchange rate risks and asset prices in a small open economy By Alexis Derviz
  6. Productivity shocks, budget deficits and the current account By Matthieu Bussière; Marcel Fratzscher; Gernot J. Müller
  7. Communication and exchange rate policy By Marcel Fratzscher
  8. Do options-implied RND functions on G3 currencies move around the times of interventions on the JPY/USD exchange rate? By Olli Castrén
  9. Do financial market variables show (symmetric) indicator properties relative to exchange rate returns? By Olli Castrén
  10. Non-fundamental exchange rate volatility and welfare By Roland Straub; Ivan Tchakarov
  11. Foreign exchange option and returns based correlation forecasts - evaluation and two applications By Olli Castrén; Stefano Mazzotta
  12. The European Monetary Union as a commitment device for new EU member states By Federico Ravenna
  13. Towards the estimation of equilibrium exchange rates for CEE acceding countries: methodological issues and a panel cointegration perspective. By Francisco Maeso-Fernandez; Chiara Osbat; Bernd Schnatz
  14. Trade effects of the euro - evidence from sectoral data By Richard Baldwin; Frauke Skudelny; Daria Taglioni
  15. Welfare implications of joining a common currency By Michele Ca’ Zorzi; Roberto A. De Santis; Fabrizio Zampolli
  16. The Impact of FX Central Bank Intervention in a Noise Trading Framework By Michel Beine; Paul De Grauwe; Marianna Grimaldi
  17. Exchange-rate policy and the zero bound on nominal interest rates By Günter Coenen; Volker Wieland
  18. Import prices and pricing-to-market effects in the euro area By Thomas Warmedinger
  19. Financial Liberalization and Inflationary Dynamics in the Context of a Small Open Economy By Rangan Gupta
  20. Stocks, bonds, money markets and exchange rates - measuring international financial transmission By Michael Ehrmann; Marcel Fratzscher; Roberto Rigobon
  21. On the determinants of euro area FDI to the United States: the knowledge- capital- Tobin's Q framework By Roberto A. De Santis; Robert Anderton
  22. Fundamentals and joint currency crises By Philipp Hartmann; Stefan Straetmans; Caspar G. de Vries
  23. The demand for euro area currencies By Björn Fischer; Petra Köhler; Franz Seitz
  24. The information content of over-the-counter currency options By Peter Christoffersen; Stefano Mazzotta
  25. On PPP, Unit Roots and Panels By Wagner, Martin
  26. The Governor or the Sheriff? Pacific Island Nations and Dollarization. By Chakriya Bowman
  27. Monetary policy shocks in the euro area and global liquidity spillovers By João Sousa; Andrea Zaghini
  28. Current account dynamics in OECD and EU acceding countries - an intertemporal approach By Matthieu Bussière; Marcel Fratzscher; Author-Name: Gernot J. Müller
  29. The determinants of the overnight interest rate in the euro area By Julius Moschitz
  30. Monetary policy predictability in the euro area: an international comparison By Bjørn-Roger Wilhelmsen; Andrea Zaghini
  31. Does the yield spread predict recessions in the euro area? By Fabio Moneta
  32. Euro area inflation differentials By Ignazio Angeloni; Michael Ehrmann
  33. A look at intraday frictions in the euro area overnight deposit market By Vincent Brousseau; Andrés Manzanares
  34. Adopting the Euro in Central Europe: Challenges of the Next Step in European Integration By Schadler, Susan; Drummond, Paulo Flavio Nacif; Kuijs, Louis; Murgasova, Zuzana; van Elkan, Rachel
  35. Has euro-area inflation persistence changed over time? By Gerard O'Reilly; Karl Whelan
  36. Measuring market and inflation risk premia in France and in Germany By Lorenzo Cappiello; Stéphane Guéné

  1. By: Menkhoff, Lukas; Rebitzky, Rafael; Schröder, Michael
    Abstract: This paper extends earlier studies on exchange rate expectations' formation by using new data and adding information about forecasters' reliance on fundamental analysis for the first time. We replicate the conventional result of non rational expectations. Moreover, biases in expectations are identified as professionals significantly belief too much in mean reversion, mean being represented by PPP. When respondents are grouped on their reliance to fundamental analysis, fundamentalists reveal an even stronger bias. Those, who rely the least on fundamentals preferring technical analysis instead , show a significantly smaller bias towards PPP in lieu of expecting too much trend extrapolation. Biased beliefs will grow stronger when the US Dollar is further away from PPP. Finally, the accuracy of the expectations is poor for both groups however we find directional forecasting ability.
    Keywords: Exchange rate expectations, forecasting, fundamental analysis, technical analysis, purchasing power parity
    JEL: F31 G14
    Date: 2005–09
  2. By: Flandreau, Marc; Komlos, John
    Abstract: A natural experiment with an exchange-rate band in Austria-Hungary in the early 20th century provides a rare opportunity to discuss critical aspects of the theory of target zones. Providing a new derivation of the target zone model as a set of nested hypotheses, the inference is drawn that policy credibility and market efficiency were paramount in the success of the Austro-Hungarian experience.
    Keywords: Austria-Hungary; covered interest parity; credibility; market efficiency hypothesis; monetary model; monetary policy; target zone
    JEL: F31 N32
    Date: 2005–08
  3. By: Michael Ehrmann (European Central Bank); Marcel Fratzscher (European Central Bank)
    Abstract: This paper analyses the link between economic fundamentals and exchange rates by investigating the importance of real-time data. We find that such economic news in the United States, Germany and the euro area have indeed been a driving force behind daily US dollar – euro/DEM exchange rate developments in the period 1993-2003. The larger importance of US macroeconomic news is at least partly explained by their earlier release time compared to corresponding German and euro area news. The exchange rate is also shown to respond more strongly to news in periods of large market uncertainty and when negative or large shocks occur. Overall, the model based on real-time data is capable of explaining about 75% of the monthly directional changes of the US dollar-euro exchange rate, although it does not explain well the magnitude of the exchange rate changes.
    Keywords: exchange rates; fundamentals; announcements; news; real-time data; United States; euro area; interdependence; US dollar euro; EMU.
    JEL: F31 F42 E52
    Date: 2004–05
  4. By: Francis Breedon (The Business School, Imperial College London, South Kensington Campus, 53 Prince’s Gate, London SW7 2AZ, United Kingdom); Paolo Vitale (Department of Economics and Land History, Gabriele D’Annunzio University, Viale Pindaro 42, 65127 Pescara, Italy)
    Abstract: We propose a simple structural model of exchange rate determination which draws from the analytical framework recently proposed by Bacchetta and van Wincoop (2003) and allows us to disentangle the liquidity and information effects of order flow on exchange rates. We estimate this model employing an innovative transaction data-set that covers all direct foreign exchange transactions completed in the USD/EUR market via EBS and Reuters between August 2000 and January 2001. Our results indicate that the strong contemporaneous correlation between order flow and exchange rates is mostly due to liquidity effects. This result also appears to carry through to the four FX intervention events that appear in our sample.
    Keywords: Order Flow; Foreign Exchange Micro Structure; Exchange Rate Dynamics.
    JEL: D82 G14 G15
    Date: 2004–12
  5. By: Alexis Derviz (Czech National Bank, Na P?íkop? 28, CZ-115 03 Praha 1, Czech Republic)
    Abstract: The paper proposes a multi-factor international asset pricing model in which the exchange rate is allowed to be co-determined by a risk factor imperfectly correlated to other priced risks in the economy. The significance of this factor can be established as long as one is able to observe a proxy for the foreign cash order flow. Then, the asset pricing model is decomposed into the standard ICCAPM no-arbitrage setup characterized by a pricing kernel, in which, however, the “autarky” exchange rate is unobserved, and an additional equation that links this autarchic currency price with the FX order flow. The model is put in the state space form. The unobserved variables span the macroeconomic risk factors with an impact on the asset markets and determine the dynamics of the pricing kernel, the autarchic exchange rate and the FX order flow. A comparison of models allowing for an independent OF risk factor with a restricted one, where the forex order flow plays no role, should disclose the existence of a “nonfundamental” source of a systematic divergence of the observed and the autarchic (i.e. fundamental) FX returns. The model is calibrated and tested on the Czech koruna/euro exchange rate in a setting with seven Czech and euro area asset returns.
    Keywords: Exchange rate; Pricing kernel; Order flow; Latent risk; State space.
    JEL: F31 F41 G12 G15
    Date: 2004–03
  6. By: Matthieu Bussière (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany); Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany); Gernot J. Müller (Goethe University Frankfurt, Mertonstr. 17, D-60325 Frankfurt am Main, Germany)
    Abstract: Currently the U.S. is experiencing record budget and current account deficits, a phenomenon familiar from the "Twin Deficits" discussion of the 1980s. In contrast, during the 1990s productivity growth has been identified as the primary cause of the US current account deficit. We suggest a theoretical framework which allows to evaluate empirically the relative importance of budget deficits and productivity shocks for the determination of the current account. Using a sample of 21 OECD countries and time series data from 1960 to 2003 we find little evidence for a contemporaneous effect of budget deficits on the current account, while country-specific productivity shocks appear to play a key role.
    Keywords: Current account, productivity, investment, budget deficit.
    JEL: E62 F32 F41
    Date: 2005–08
  7. By: Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper deals with the very short-term influence of "oral interventions" on the exchange rate of major currencies. The paper finds that official communication, as reported by wire services, are effective in influencing the US dollar-euro and yen-US dollar exchange rates in the desired direction on intervention days. Oral interventions are found to be substantially more effective if they deviate from the prevalent policy "mantra". They also tend to reduce market volatility whereas actual interventions raise volatility. A key result of the paper is that oral interventions are effective independently from the stance and direction of monetary policy as well as the occurrence of actual interventions. This suggests that oral interventions might constitute, on a short-term basis, an effective and largely autonomous policy tool.
    Keywords: communication; exchange rate; intervention; policy; United States; euro area; Japan.
    JEL: E61 E58 F31
    Date: 2004–05
  8. By: Olli Castrén (DG Economics, European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.)
    Abstract: This paper focuses on changes in the currency options market’s assessment of likely future exchange rate developments around the times of official interventions in the JPY/USD exchange rate. We estimate the options-implied risk-neutral density functions (RNDs) using daily OTC quotes for options prices with fixed moneyness that avoids the biases that typically characterise the exchange traded price quotes. We find that the episodes of interventions on the JPY/USD exchange rate coincide with systematic changes in all moments of the estimated RNDs on the JPY/USD currency pair, and in several of the moments of the estimated RNDs on the JPY/EUR and USD/EUR currency pairs. In particular, the operations where Japanese yen is sold coincide with a movement in the mean of the RND towards a weaker yen both against the US dollar and the euro, as well as with an increase in implied standard deviations. Prior to the interventions, the RNDs tend to move into opposite direction suggesting, on the average, increasingly unfavourable market conditions and leaning-against-the wind by the Japanese authorities.
    Keywords: Foreign exchange market intervention; option-implied distributions; GARCH estimation.
    JEL: E58 F31 F33
    Date: 2004–11
  9. By: Olli Castrén (European Central Bank, DG Economics)
    Abstract: This paper assesses the contemporaneous, leading and lagging indicator properties of financial market variables relative to movements in six major developed country currency pairs. As indicator variables changes in various relative asset prices, short-term portfolio flows and currency options data are used. We find that changes in equity index differentials, short-term speculative flows and risk reversals on currency options prices exhibit consistent contemporaneous indicator properties and leading indicator properties for several currency pairs. Since 1999, changes in short-term interest rate differentials have gained importance as indicators. The best indicator variables explain over 50% of monthly returns of the USD/EUR and GBP/USD exchange rates and over 60% of the appreciation and depreciation episodes of the USD/EUR and JPY/EUR currency pairs.
    Keywords: Exchange rates, asset prices, capital flows, leading and lagging indicators, market microstructure.
    JEL: F31 F32 G15
    Date: 2004–07
  10. By: Roland Straub (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany); Ivan Tchakarov (International Monetary Fund, 700 19th Street, N.W. Washington, D.C. 20431, USA)
    Abstract: We lay out an empirical and a theoretical model to analyze the effects of non-fundamental exchange rate volatility on economic activity and welfare. In the first part of the paper, the GARCH-SVARmodel is applied to measure empirically the effect of the conditional exogenous exchange rate volatility on the conditional mean of the endogenous variables in our open economy VAR. Our results for Canada, Germany and UK indicate that the effects of exchange rate uncertainty are small empirically. In the second part, we investigate the effect of non-fundamental exchange rate volatility in a stochastic open economy model. The second order approximation method of Sims [2003] is applied to the model equilibrium conditions. We show that in a model with habit persistence, even non-fundamental exchange rate volatility that generate only small variation in the unconditional mean of the variables might induce economically significant welfare changes.
    Keywords: GARCH-SVAR; Exchange rate volatility; Second-order approximation; Welfare;
    JEL: C32 F31 F41
    Date: 2004–04
  11. By: Olli Castrén (Corresponding author: DG-Economics, European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); Stefano Mazzotta (McGill University - Faculty of Management, 1001 Sherbrooke St.West, Montreal, Quebec H3A1G5, Canada.)
    Abstract: We compare option-implied correlation forecasts from a dataset consisting of over 10 years of daily data on over-the-counter (OTC) currency option prices to a set of return-based correlation measures and assess the relative quality of the correlation forecasts. We find that while the predictive power of implied correlation is not always superior to that of returns based correlations measures, it tends to provide the most consistent results across currencies. Predictions that use both implied and returns-based correlations generate the highest adjusted R2s, explaining up to 42 per cent of the realised correlations. We then apply the correlation forecasts to two policyrelevant topics, to produce scenario analyses for the euro effective exchange rate index, and to analyse the impact on cross-currency co-movement of interventions on the JPY/USD exchange rate.
    Keywords: Correlation forecasts; currency options data; effective exchange rate.
    JEL: F31 G15
    Date: 2005–02
  12. By: Federico Ravenna (Economics Department, 401 E2 Building, University of California, Santa Cruz, CA 95064, US)
    Abstract: This paper shows that the credibility gain from permanently committing to a fixed exchange rate by joining the European Monetary Union can outweigh the loss from giving up independent monetary policy. When the central bank enjoys only limited credibility a pegged exchange rate regime yields a lower loss compared to an inflation targeting policy, even if this policy ranking would be reversed in a fullcredibility environment. There exists an initial stock of credibility that must be achieved for a policy-maker to adopt inflation targeting over a strict exchange rate targeting regime. Full credibility is not a precondition, but exposure to foreign and financial shocks and high steady state inflation make joining the EMU relatively more attractive for a given level of credibility. The theoretical results are consistent with empirical evidence we provide on the relationship between credibility and monetary regimes using a Bank of England survey of 81 central banks.
    Keywords: Inflation targeting; Credibility; Open Economy; Exchange Rate. Regimes, Monetary Policy
    JEL: E52 E31 F02 F41
    Date: 2005–08
  13. By: Francisco Maeso-Fernandez (University of Murcia, Spain.); Chiara Osbat (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt/Main, Germany.); Bernd Schnatz (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt/Main, Germany.)
    Abstract: This paper discusses methodological issues relating to the estimation of the long-run relationship between exchange rates and fundamentals for Central and Eastern European acceding countries. Given limited data availability and reliability and the rapid structural change acceding countries have been undergoing, we identify several pitfalls of standard econometric procedures. We analyse the merits of a two-step strategy that consists of estimating the relationship between exchange rates and fundamentals in a panel cointegration setting excluding acceding countries from the sample - and then “extrapolating” the estimated relationships. While focusing on the first step of such a strategy, the paper also discusses technical aspects underlying the “extrapolation” stage. As a result, the paper endows the reader with the methodological and empirical ingredients for computing equilibrium exchange rates for acceding countries, providing estimates for the long-run coefficients and a discussion of how to apply these results to acceding countries data.
    Keywords: Equilibrium exchange rates; Acceding Countries; Panel Cointegration; BEER.
    JEL: C23 F31
    Date: 2004–04
  14. By: Richard Baldwin (University of Geneva - Graduate Institute of International Studies (HEI), CH-1202 Geneva, Switzerland.); Frauke Skudelny (Corresponding author: European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); Daria Taglioni (University of Geneva - Graduate Institute of International Studies (HEI), CH-1202 Geneva, Switzerland.)
    Abstract: This paper contributes to the literature on the impact of EMU on trade, adding two new elements. First, we propose a theoretical model for explaining how the euro could have increased trade by the large amounts found in the empirical literature. Second, we propose a sectoral dataset to test the insights from the theory. Our theoretical model shows that in a monopolistic competition set-up, the effect of exchange rate uncertainty on trade has nonlinear features, suggesting that EMU and a standard measure for exchange rate uncertainty should be jointly significant. Our empirical results confirm this finding, with a trade creating effect between 108 and 140% in a pooled regression, and between 54 to 88% when sectors are estimated individually. Importantly, we find evidence for a trade creating effect also for trade with third countries.
    Keywords: Rose effect; exchange rate volatility; monetary union; sectoral trade; gravity.
    JEL: F12 C33 E0
    Date: 2005–02
  15. By: Michele Ca’ Zorzi (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); Roberto A. De Santis (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); Fabrizio Zampolli
    Abstract: This paper examines the welfare implications of a country joining a currency union as opposed to operating in a flexible exchange rate regime. At the country level, the suboptimal response to domestic and foreign shocks and the inability of setting inflation at the desired level may be offset by a positive impact on potential output. We show that for entry to be welfare enhancing, the potential output gain must be the larger, the smaller the country, the larger the difference between the standard deviation of supply shocks across the participating countries, the smaller the correlation of countries’ supply shocks and the larger the variance of real exchange rate shocks.
    Keywords: Balassa-Samuelson Effect; Currency Union; Monetary Policy; Welfare.
    JEL: E52 E58 F33 F40
    Date: 2005–02
  16. By: Michel Beine; Paul De Grauwe; Marianna Grimaldi
    Abstract: In this paper we investigate the effects of central bank interventions (CBI) in a noise trading model with chartists and fundamentalists. We first estimate a model in which chartists extrapolate past returns and fundamentalists forecast a mean reverting dynamics of the exchange rate towards a fundamental value. Then, we investigate the role of central bank interventions in explaining the switching properties between the two types of agents. We find evidence that in the medium run, interventions increase the proportion of fundamentalists and therefore exert some stabilizing influence on the exchange rate.
    JEL: F31 F33
    Date: 2005
  17. By: Günter Coenen (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt/Main, Germany.); Volker Wieland (Professur für Geldtheorie und -politik, Johann-Wolfgang-Goethe Universität, Mertonstrasse 17, D-60325 Frankfurt am Main, Germany.)
    Abstract: In this paper, we study the effectiveness of monetary policy in a severe recession and deflation when nominal interest rates are bounded at zero. We compare two alternative proposals for ameliorating the effect of the zero bound: an exchange-rate peg and price-level targeting. We conduct this quantitative comparison in an empirical macroeconometric model of Japan, the United States and the euro area. Furthermore, we use a stylized micro-founded two-country model to check our qualitative findings. We find that both proposals succeed in generating inflationary expectations and work almost equally well under full credibility of monetary policy. However, price-level targeting may be less effective under imperfect credibility, because the announced price-level target path is not directly observable.
    Keywords: monetary policy rules; zero-interest-rate bound; liquidity trap; nominal rigidities; exchange rates.
    JEL: E31 E52 E58 E61
    Date: 2004–04
  18. By: Thomas Warmedinger (European Central Bank, Directorate General Research)
    Abstract: Pricing-to-market (PTM) behaviour implies that exporters adjust their prices to the prevailing prices in their export markets. For the importing country, PTM effects can be interpreted as a measure of the stability of domestic prices against foreign price and exchange rate developments. PTM behaviour can be attributed to the level of competitiveness and price stickiness in the importing country. This paper investigates PTM behaviour in the euro area from the importing country’s perspective, for both individual countries and the euro area as a whole. Analysis firstly involves the estimation of PTM effects in the five largest euro area countries. Secondly, PTM effects in the euro area as a whole are estimated to be slightly higher than one half. The results from illustrative simulations suggest that the increase in euro-area inflation during the first two years of monetary union can be largely attributed to oil price and exchange rate developments.
    Keywords: Printing-to-market, import prices, exchange-rate pass-through, euro area.
    JEL: C32 E31 F14 F47
    Date: 2004–01
  19. By: Rangan Gupta (University of Connecticut and University of Pretoria)
    Abstract: The paper develops a short-run model of a small open financially repressed economy characterized by unorganized money markets, capital good imports, capital mobility, wage indexation, and flexible exchange rates. The analysis shows that financial liberalization, in the form of an increased rate of interest on deposits and tight monetary policy, unambiguously and unconditionally causes deflation. Moreover, the results do not depend on the degree of capital mobility and structure of wage setting. The paper recommends that a small open developing economy should deregulate interest rates and tighten monetary policy if reducing inflation is a priority. The pre-requisite for such a policy, however, requires the establishment of a flexible exchange rate regime.
    Keywords: Financial Liberalization; Inflation; Small open economy.
    JEL: E31 E44 E52 F41
    Date: 2005–07
  20. By: Michael Ehrmann (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt, Germany); Marcel Fratzscher (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); Roberto Rigobon (Massachusetts Institute of Technology, Cambridge MA 02142-1347, USA.)
    Abstract: The paper presents a framework for analyzing the degree of financial transmission between money, bond and equity markets and exchange rates within and between the United States and the euro area. We find that asset prices react strongest to other domestic asset price shocks, and that there are also substantial international spillovers, both within and across asset classes. The results underline the dominance of US markets as the main driver of global financial markets - US financial markets explain, on average, more than 25% of movements in euro area financial markets, whereas euro area markets account only for about 8% of US asset price changes. The international propagation of shocks is strengthened in times of recession, and has most likely changed in recent years - prior to EMU, the paper finds smaller international spillovers.
    Keywords: International financial markets; integration; transmission; financial market linkages; identification; heteroskedasticity; asset pricing; United States; euro area.
    JEL: E44 F3 C5
    Date: 2005–03
  21. By: Roberto A. De Santis (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany); Robert Anderton (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany)
    Abstract: The long-run determinants of euro area FDI to the United States during the period 1980-2001 are explained by employing the Tobin's Q-model of investment. By using the fixed effects panel estimator, stock market developments in the euro area countries including a measure adjusted for economic developments common to both the United States and the euro area - are found to influence euro area FDI to the United States. Moreover, the inclusion of the Tobin's Q enhances the traditional knowledge-capital framework specification. Overall, the empirical findings suggest that euro area patents (ownership advantage), various variables related to productivity in the United States (location advantage), the volume of bilateral telephone traffic to the United States relative to euro area GDP (ownership advantage), euro area stock market developments (Tobin's Q), and the real exchange rate are statistically significant determinants of euro area FDI to the United States.
    Keywords: Euro area; Foreign Direct Investment; Multinational firms; Tobin's Q.
    JEL: F21 F23
    Date: 2004–04
  22. By: Philipp Hartmann (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany); Stefan Straetmans (University of Maastricht - Limburg Institute of Financial Economics (LIFE), Faculty of Economics - Finance Department, P.O. Box 616, NL-6200 MD Maastricht, Netherlands); Caspar G. de Vries (Faculty of Economics, Erasmus University Rotterdam)
    Abstract: In this note we demonstrate that in affine models for bilateral exchange rates, the nature of return interdependence during crises depends on the tail properties of the fundamentals' distributions. We denote crisis linkages as either strong or weak, in the sense that the dependence remains or vanishes asymptotically. We show that if one currency return reaches crisis levels, the probability that the other currency breaks down as well vanishes asymptotically if the fundamentals' distributions exhibit light tails (like e. g. the normal). However, if the marginal distributions exhibit heavy tails, the probability that the other currency breaks down as well remains strictly positive even in the limit. This result implies that linearity and heavy tails are sufficient conditions for joint or contagious currency crises to happen systematically through fundamentals.
    Keywords: Financial Crises; Currency market linkages; Fundamentals; Heavy Tails; Asymptotoc Dependence
    JEL: G12 F31 G39 C49
    Date: 2004–03
  23. By: Björn Fischer (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany); Petra Köhler (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany); Franz Seitz (Fachhochscule Amberg-Weiden)
    Abstract: The present paper analyses currency in circulation in the euro area since the beginning of the 1980s. After a comprehensive literature review on this topic we present some stylised facts on currency holdings in the euro area countries as well as at an aggregate euro area level. The next chapter develops a theoretical model, which extends traditional money demand models to also incorporate arguments for the informal economy and foreign demand for specific currencies. In the empirical sections we first estimate the demand for euro legacy currencies in total and for small and large denominations within a cointegration framework. We find significant differences between the determinants of holdings of small and large denominations as well as overall currency demand. While small-value banknotes are mainly driven by domestic transactions, the demand for large-value banknotes depends on a short-term interest rate, the exchange rate of the euro as a proxy for foreign demand and inflation variability. Large-value banknotes seem to be therefore used to an important extent as a store of value domestically and abroad. As monetary policy is mainly interested in getting information on the demand for currency used for domestic transactions we also try several approaches in this direction. All the methods applied result in rather low levels of transaction balances used within the euro area of around 25% to 35% of total currency. After this we deal with possibly changing cost-benefit-considerations of the use of cash due to the introduction of euro notes and coins. Overall, there seems no evidence so far of a substantial decline of the demand for currency in the euro area. The analysis of currency in circulation and in particular estimates on the share of currency which is likely to be used for domestic transactions therefore help to explain monetary developments and are informative for monetary policy.
    Keywords: currency in circulation; Cointegration; Purposes of holding currency
    JEL: E41 E52 E58
    Date: 2004–04
  24. By: Peter Christoffersen (Faculty of Management, McGill University); Stefano Mazzotta (Department of Economics & Finance, Coles College of Business, Kennesaw State University)
    Abstract: Financial decision makers often consider the information in currency option valuations when making assessments about future exchange rates. The purpose of this paper is to systematically assess the quality of option based volatility, interval and density forecasts. We use a unique dataset consisting of over 10 years of daily data on over-the-counter currency option prices. We find that the OTC implied volatilities explain a much larger share of the variation in realized volatility than previously found using market-traded options. Finally, we find that wide-range interval and density forecasts are often misspecified whereas narrow-range interval forecasts are well specified.
    Keywords: FX, Volatility, Interval, Density, Forecasting.
    JEL: G13 G14 C22 C53
    Date: 2004–06
  25. By: Wagner, Martin (Department of Economics and Finance, Institute for Advanced Studies, Vienna, Austria)
    Abstract: This paper re-assesses the panel (unit root test) evidence for PPP on four monthly data sets. We discuss and illustrate that commonly-used first generation panel unit root tests are inappropriate for PPP analysis since they are constructed for cross-sectionally uncorrelated panels. Given that real exchange rate panel data sets are – almost by construction – highly cross-sectionally correlated, so called second generation panel unit root methods that allow for and model cross-sectional dependence should be applied. Using inappropriate first generation tests, quite strong evidence for PPP is found. However, this evidence vanishes entirely when resorting to an appropriate method (e.g. the one developed in Bai and Ng, 2004a) for nonstationary cross-sectionally correlated panels. We strongly believe that our findings are relevant beyond the data sets investigated here for illustration.
    Keywords: PPP, Real exchange rate index, Unit root, Panel, Cross-sectional dependence, Factor model
    JEL: C23 F30 F31
    Date: 2005–09
  26. By: Chakriya Bowman (Asia Pacific School of Economics and Government, The Australian National University)
    Abstract: Recent political discussions in Australia have suggested that Pacific Island nations should “dollarize” to the Australian dollar. This is seen as a way to stabilise the economies of the region, which have been fraught with both political and economic uncertainty. Standard currency analysis techniques indicate that dollarization to the US dollar may be preferable to dollarization with the Australian dollar, as strong existing links with the US dollar are indicated, while there is less evidence to support existing relationships with the Australian dollar. With Asia likely to overtake Australia as a dominant trading partner for major Pacific Island economies, a discussion of currency reform in the Pacific should at least consider US dollarization, as Australia’s economic influence may not be as significant as previously assumed.
    Keywords: foreign exchange, dollarization, monetary relations
    JEL: F31 E42
    Date: 2005–02
  27. By: João Sousa (Banco de Portugal,Av. Almirante Reis 71, P-1150-012 Lisbon, Portugal.); Andrea Zaghini (European Central Bank, Directorate Monetary Policy, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.)
    Abstract: This paper analyses the international transmission of monetary shocks with a special focus on the effects of foreign money ("global liquidity") on the euro area. We estimate structural VAR models for the euro area and the global economy including a global liquidity aggregate. The impulse responses obtained show that a positive shock to extra-euro area liquidity leads to permanent increases in the euro area M3 aggregate and the price level, a temporary rise in real output and a temporary appreciation of the real effective exchange rate of the euro. Moreover, we find that innovations in global liquidity play an important role in explaining price and output fluctuations in the euro area and in the global economy.
    Keywords: Monetary policy; Structural VAR; International spillovers.
    JEL: E52 F01
    Date: 2004–02
  28. By: Matthieu Bussière (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany); Marcel Fratzscher (European Central Bank, Kaiserstr. 29, D-60311 Frankfurt am Main, Germany); Author-Name: Gernot J. Müller (Department of Economics, European University Institute,Via della Piazzuola 43, I-50133 Florence)
    Abstract: The paper extends the standard intertemporal model of the current account to include two important stylised facts: (1) the persistence of current account positions and (2) the relevance of the fiscal balance. Specifically, the paper derives a closed form solution for consumption in the presence of habit persistence and liquidity constraints, which allows us to obtain a dynamic model for the current account where fiscal deficits have an effect. The model is estimated for a panel of 33 countries, including the ten EU acceding countries and structural current account positions are derived. A parsimonious specification including relative income, relative investment and the fiscal balance explains well past current account developments. A key finding of the paper is that, from an intertemporal perspective, current accounts in most acceding countries are currently broadly in line with their structural current account positions.
    Keywords: Current account; Habit persistence; Liquidity constraints; Panel regressions; Acceding countries.
    JEL: F32 F41
    Date: 2004–02
  29. By: Julius Moschitz (Universitat Autònoma de Barcelona, Dept. d’Economia i d’Història Econòmica, 08193 Bellaterra, Barcelona, Spain.)
    Abstract: The overnight interest rate is the price paid for one day loans and defines the short end of the yield curve. It is the equilibrium outcome of supply and demand for bank reserves. This paper models the intertemporal decision problems in the reserve market for both central and commercial banks. All important institutional features of the euro area reserve market are included. The model is then estimated with euro area data. A permanent change in reserve supply of one billion euro moves the overnight rate by eight basis points into the opposite direction, hence, there is a substantial liquidity effect. Most of the predictable patterns for the mean and the volatility of the overnight rate are related to monetary policy implementation, but also some calendar day effects are present. Banks react sluggishly to new information. Implications for market efficiency, endogeneity of reserve supply and underbidding are studied.
    Keywords: Money markets; EONIA rate; Liquidity effect; Central bank operating procedures.
    JEL: E52 E58 E43
    Date: 2004–09
  30. By: Bjørn-Roger Wilhelmsen (Norges Bank, Bankplassen 2, 0107 Oslo, Norway); Andrea Zaghini (Banca d’Italia, Servizio Studi, Via Nazionale 91, 00184 Roma, Italy)
    Abstract: The paper evaluates the ability of market participants to anticipate monetary policy decisions in the euro area and in 13 other countries. First, by looking at the magnitude and the volatility of the changes in the money market rates we show that the days of policy meetings are special days for financial markets. Second, we find that the predictability of the ECB’s monetary policy is fully comparable (and sometimes slightly better) to that of the FED and the Bank of England. Finally, an econometric analysis of the ability of market participants to incorporate in the current money rates the expected changes in the key policy rate shows that in the euro area policy decisions are anticipated well in advance.
    Keywords: Monetary policy; Predictability; Money market rates.
    JEL: E4 E5 G1
    Date: 2005–07
  31. By: Fabio Moneta (Finance Department, Carroll School of Management, Boston College, 140 Commonwealth Avenue, Chestnut Hill, MA 02467-3808.)
    Abstract: This paper studies the informational content of the slope of the yield curve as a predictor of recessions in the euro area. In particular, the historical predictive power of ten yield spreads, for different segments of the yield curve, is tested using a probit model. The yield spread between the ten-year government bond rate and the threemonth interbank rate outperforms all the other spreads in predicting recessions in the euro area. The result is confirmed when the autoregressive series of the state of the economy is added in the same model. The forecast accuracy of the spread between 10-year and 3-month interest rates is explored in an exercise of out-of-sample forecasting. This yield spread appears to contain information which goes beyond the information already available in the history of output, providing further evidence of the potential usefulness of this indicator for monetary policy purposes.
    Keywords: Probit model; forecasting; recessions; yield curve.
    JEL: E44 E52 C53
    Date: 2003–12
  32. By: Ignazio Angeloni (Dipartimento del Tesoro, Mnistero dell'Economia e delle Finanze.); Michael Ehrmann (Directorate General Research, European Central Bank, Kaiserstrasse, 29, 60311, Frankfurt am Main, Germany.)
    Abstract: We build a stylised 12-country model of the euro area and use it to analyse why differences in national inflation and growth rates arise within the European monetary union. We find that inflation persistence is a key potential explanatory factor. Other more frequently mentioned reasons, like country-specific shocks or differences in the monetary transmission mechanism across countries, count less. We also look at how a monetary policy geared to area-wide average inflation affects these differentials. Our model suggests that area-wide inflation stability and low inflation differentials are complementary.
    Keywords: Currency union; inflation differentials; inflation persistence; euro area.
    JEL: E31 E32 E52 F42
    Date: 2004–09
  33. By: Vincent Brousseau (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Andrés Manzanares (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper studies frictions in the euro area interbank deposit overnight market, making use of high frequency individual quote and trade data. The aim of the analysis is to determine, in a quantitative way, how efficient this market is. Besides a comprehensive descriptive analysis, the approach used defines a measure of the friction arising for each single transaction, by which we understand an (small) initial loss accepted by a counterparty, and the corresponding gain made by the other counterparty. The evolution of total daily frictions is then put into perspective comparing it with the frictions arising if flows corresponded to the optimal solution of a “cash transportation problem”. The main conclusions of this exercise are that overall frictions, although small in absolute size, tend to increase strongly whenever the overnight rate becomes volatile. Some tentative explanations for this are given, relying on the introduced methodology.
    Keywords: Financial market microstructure; Money Market; Market friction; Network optimization problems.
    JEL: D4 E52 C61
    Date: 2005–02
  34. By: Schadler, Susan; Drummond, Paulo Flavio Nacif; Kuijs, Louis; Murgasova, Zuzana; van Elkan, Rachel
    Abstract: Upon entry into the European Union (EU), countries become members of the Economic and Monetary Union (EMU), with a derogation from adopting the euro as their currency (that is, each country joining the EU commits to replace its national currency with the euro, but can choose when to request permission to do so). For most of these countries, adopting the euro will entail major economic change. This paper examines likely economic developments and policy challenges for the five former transition countries in central Europe--the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia--that joined the EU in May 2004 and operate independent monetary policies but have not yet achieved policy convergence with the rest of the euro area.
    Date: 2005
  35. By: Gerard O'Reilly (Central Bank and Financial Services Authority of Ireland); Karl Whelan (Central Bank and Financial Services Authority of Ireland)
    Abstract: This paper analyzes the stability over time of the econometric process for Euro-area inflation since 1970, focusing in particular on the behaviour of the so-called persistence parameter (the sum of the coefficients on the lagged dependent variables). Perhaps surprisingly, in light of the Lucas critique, our principal finding is that there appears to be relatively little instability in the parameters of the Euro-area inflation process. Full-sample estimates of the persistence parameter are generally close to one, and we fail to reject the hypothesis that this parameter has been stable over time. We discuss how these results provide some indirect evidence against rational expectations models with strong forward-looking elements, such as the New-Keynesian Phillips curve.
    Keywords: Inflation Persistence; Euro Area; Lucas Critique.
    JEL: E31 E52
    Date: 2004–04
  36. By: Lorenzo Cappiello (European Central Bank); Stéphane Guéné (European Central Bank)
    Abstract: This paper studies the role of inflation in the determination of financial asset prices. We estimate an Intertemporal Capital Asset Pricing Model à la Merton (1973), with inflation as an independent source of risk, for France and Germany. Our study also allows us to evaluate how the different nature of the French and German monetary policies before 1999 as well as the convergence process towards the single currency might have affected the role of inflation in the pricing of financial assets. We find that inflation is a significant explanatory factor for the pricing of stocks and government bonds in the two countries. Moreover, while there seems to be no clear structural break in the impact of inflation on asset prices after Stage Three of Economic and Monetary Union, such an impact has been increasingly similar in the two countries after 1999.
    Keywords: Intertemporal CAPM, business cycles, GARCH-in-Mean
    JEL: C32 C61 E44 G12
    Date: 2005–02

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