nep-ifn New Economics Papers
on International Finance
Issue of 2006‒02‒12
eleven papers chosen by
Yi-Nung Yang
Chung Yuan Christian University

  1. Purchasing Power Parity and Heterogenous Mean Reversion By Koedijk, Kees; Tims, Ben; Van Dijk, Mathijs A
  2. Monetary policy and exchange rate interactions in a small open economy By Bjørnland, Hilde C.
  3. Real GDP in Pre-War East Asia: A 1934-36 Benchmark Purchasing Power Parity Comparison with the U.S. By Kyoji Fukao; Debin Ma; Tangjun Yuan
  4. Openness and the case for flexible exchange rates By Giancarlo Corsetti
  5. The Social Cost of Foreign Exchange Reserves By Rodrik, Dani
  6. Lessons from Italian Monetary Unification By James Foreman-Peck
  7. From Transition Crises to Macroeconomic Stability? Lessons from a Crises Early Warning System for Eastern European and CIS Countries By Kristina Kittelmann; Marcel Tirpak; Rainer Schweickert; Lúcio Vinhas de Souza
  8. AMU Deviation Indicator for Coordinated Exchange Rate Policies in East Asia and its Relation with Effective Exchange Rates By Eiji Ogawa; Junko Shimizu
  9. Exchange Rate Regimes, Capital Account Opening and Real Exchange Rates: Evidence from Thailand By Juthathip Jongwanich
  10. DSGE Models of High Exchange-Rate Volatility and Low Pass-Through By Giancarlo Corsetti; Luca Dedola; Sylvain Leduc
  11. The commodity currency puzzle By Bjørnland, Hilde C.; Hungnes, Håvard

  1. By: Koedijk, Kees; Tims, Ben; Van Dijk, Mathijs A
    Abstract: This paper analyses the properties of multivariate tests of purchasing power parity (PPP) that fail to take heterogeneity in the speed of mean reversion across real exchange rates into account. We compare the performance of homogeneous and heterogeneous unit root testing methodologies. The recent literature has successfully contested several severe restrictions on the structure of the model, but the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored. Using Monte Carlo simulation, we uncover important adverse properties of the methodology that relies on homogeneous estimation and testing. More specifically, power functions are low and assume irregular shapes. Furthermore, homogeneous estimates of the mean reversion parameters exhibit potentially large biases. This can have a dramatic impact on inferences made on the validity of the PPP hypothesis. Our findings highlight the importance of allowing for heterogeneous estimation when testing for a unit root in panels of real exchange rates.
    Keywords: heterogeneity; international economics; panel models; Purchasing power parity; real exchange rates; unit root tests
    JEL: F31 F33 G15
    Date: 2006–01
  2. By: Bjørnland, Hilde C. (Dept. of Economics, University of Oslo)
    Abstract: This paper analyses the transmission mechanisms of monetary policy in a small open economy like Norway through structural VARs, paying particular attention to the interdependence between the monetary policy stance and exchange rate movements in the inflation-targeting period. Previous studies of the effects of monetary policy in open economies have typically found small or puzzling effects on the exchange rate; puzzles that may arise due to the recursive restrictions imposed on the contemporaneous interaction between monetary policy and the exchange rate. By instead imposing a long-run neutrality restriction on the real exchange rate, thereby allowing the interest rate and the exchange rate to react simultaneously to any news, the interdependence increases considerably. In particular, following a contractionary monetary policy shock, the real exchange rate appreciates immediately and thereafter depreciates back to baseline. Furthermore, output and consumer price inflation fall gradually as expected; thereby also ruling out any price puzzle that has commonly been found in the literature. Results are compared and found to be consistent with among other the findings from an “event study” that focuses on immediate responses in asset prices following a surprise monetary policy decision.
    Keywords: VAR; monetary policy; open economy; identification; event study.
    JEL: C32 E52 F31 F41
    Date: 2005–12–15
  3. By: Kyoji Fukao; Debin Ma; Tangjun Yuan
    Abstract: This article provides estimates of purchasing power parity (PPP) converters for expenditure side GDP of Japan/China and Japan/U.S through a detailed matching of prices for more than 50 types of goods and services in private consumption and about 20 items or sectors for investment and government expenditure. Based on our finding and linking with the earlier studies on the relative price levels of Taiwan and Korea, we derive the mid-1930s benchmark PPP adjusted per capita income of Japan, China, Taiwan and Korea at 31%, 10%, 23%, and 12% of the U.S. level respectively for the mid-1930s. These estimates corrected the consistent downward bias in East Asian income levels based on market exchange rate conversions. While confirming Angus Maddisonfs estimates for China and Taiwan based on the 1990 benchmark back-projection method, they do point to a 23% and 85% overestimate in his comparable figures for Japan and Korea respectively for the mid-1930s period. This article develops a preliminary theoretical and empirical framework to demonstrate the possible source of the biases in the back-projection method. We briefly discuss the implications of our findings on the initial conditions and long-term growth dynamics in East Asia and beyond.
    Date: 2006–01
  4. By: Giancarlo Corsetti
    Abstract: Models of stabilization in open economy traditionally emphasize the role of exchange rates as a substitute for nominal price flexibility in fostering relative price adjustment. This view has been recently criticized on the ground that, to the extent that prices are sticky in local currency, the exchange rate does not play the stabilizing role envisioned by the received wisdom. An important question is whether, for this very reason, stabilization policies should limit exchange rate movements, or even eliminate them altogether. In this paper, I re-assess this issue by extending the Corsetti and Pesenti (2001) model to allow for home bias in consumption, so that I can exploit the advantages of closed-form solutions. While this extension leaves most properties of the model unaffected, home bias implies that the real exchange rate in an efficient equilibrium is not constant, but fluctuates with the terms of trade. The weight that monetary authorities optimally place on stabilizing domestic marginal costs is increasing in Home bias. With asymmetric shocks, fixed exchange rates are incompatible with efficient monetary rules. Yet, the adverse welfare consequences of exchange rate movements constrain the optimal intensity of monetary responses to domestic shocks. Openness matters: the larger the import content of consumption, the lower the exchange rate volatility implied by optimal stabilization rules.
    Keywords: optimal monetary policy, nominal rigidities, exchange rate pass-through, exchange rate regimes, international cooperation
    JEL: E31 E52 F42
    Date: 2005
  5. By: Rodrik, Dani
    Abstract: There has been a very rapid rise since the early 1990s in foreign reserves held by developing countries. These reserves have climbed to almost 30% of developing countries' GDP and 8 months of imports. Assuming reasonable spreads between the yield on reserve assets and the cost of foreign borrowing, the income loss to these countries amounts to close to 1% of GDP. Conditional on existing levels of short-term foreign borrowing, this does not represent too steep a price as an insurance premium against financial crises. But why developing countries have not tried harder to reduce short-term foreign liabilities in order to achieve the same level of liquidity (thereby paying a smaller cost in terms of reserve accumulation) remains an important puzzle.
    Keywords: emerging markets; financial crises
    JEL: F4
    Date: 2006–01
  6. By: James Foreman-Peck (Cardiff Business School)
    Abstract: This paper examines whether the states brought together in the Italian monetary union of the nineteenth century constituted an optimum monetary area, either before or after unification. Interest rate shocks indicate close relations between states in northern Italy but negative correlations between the North and the South before unification, suggesting some advantages of continued Southern monetary independence. The proportion of Southern Italian trade with the North was small, in contrast to intra- Northern trade, and therefore monetary independence imposed a light burden. Changes in the wheat market indicate that the South and North after unification (though not probably because of it) increasingly specialised according to their comparative advantages. Coupled with differences in economic behaviour of the Southern economy, this meant that monetary policies appropriate for the North were less so for the South. In the face of agricultural shocks originating in the New World and in France, the South would have gained from depreciating its exchange rate against the North or against the non-Italian world. As it was, nineteenth century Italian monetary union did not create the conditions for its own success, contrary to the findings of Frankel and Rose (1998) for the later twentieth century.
    Date: 2006–01–23
  7. By: Kristina Kittelmann; Marcel Tirpak; Rainer Schweickert; Lúcio Vinhas de Souza
    Abstract: This paper uses a Markov regime-switching model to assess the vulnerability of a series of Central and Eastern European countries (i.e. Czech Republic, Hungary, Slovak Republic) and two CIS countries (i.e., Russia and Ukraine) during the period 1993–2004. For the new EU member states in Central and Eastern Europe, the results of our model show that the majority of crises in those countries can be explained by inconsistencies in the domestic policy mix and by the deterioration of macroeconomic fundamentals, as emphasized by first generation crises models, while for the CIS countries analysed, financial vulnerability type indicators were the most relevant, i.e., indicators connected with the second and third generation of crisis model better explain the vulnerability of these countries. Additionally, the set of indicators choosen by our model is rather heterogenous, supporting the superiority of a country-by-country approach.
    Keywords: EU, Central and Eastern Europe, CIS, early warning system, currency crisis, Markov switching
    JEL: F47 P20 C22
    Date: 2006–02
  8. By: Eiji Ogawa; Junko Shimizu
    Abstract: The monetary authorities in East Asian countries have been strengthening their regional monetary cooperation since the Asian Currency Crisis in 1997. In this paper, we propose a deviation measurement for coordinated exchange rate policies in East Asia to enhance the monetary authorities' surveillance process for their regional monetary cooperation. We calculate the AMU as a weighted average of East Asian currencies following the method used to calculate the European Currency Unit (ECU) and the AMU Deviation Indicators, which how the degree of deviation from the hypothetical benchmark rate for each of the East Asian currencies in terms of the AMU. Furthermore, we investigate the relationships between the AMU and its Deviation Indicators and the effective exchange rates of each East Asian currency. As a result, we found the strong relationships between the AMU or the AMU Deviation Indicators and the effective exchange rates except for some currencies. These results indicate that the AMU Deviation Indicators have positive relationship with their effective exchange rates. Accordingly, we should monitor both the AMU and the AMU Deviation Indicator for the monetary authorities' surveillance in order to stabilize effective exchange rate in terms of trader partners'currencies.
    JEL: F31 F33
    Date: 2006–01
  9. By: Juthathip Jongwanich
    Abstract: This paper examines the roles of pegged exchange rate regime and capital account opening inducing persistent RER appreciation in the lead-up to the 1997 currency crisis in Thailand. The three-sector (primary, manufacturing, and nontradable) economy-wide model is constructed and policy simulation experiments are undertaken. Key findings are imposing capital control under a pegged exchange rate regime would have averted the persistent internal RER appreciation and boom in nontradable sector. However, it would not have averted persistent external RER appreciation. Exports and output would have eventually declined because of the capital shortage. A freely floating regime only with a high developmental level of foreign exchange and financial markets would have been able to avert both persistent internal and external RERs appreciation. The export and output would have eventually increased. However, this regime would have generated fluctuations in domestic prices and output. The managed floating regime (combined with inflation targeting) would have helped reduce such adverse effects while retaining the benefit from exchange rate flexibility. In a context where the foreign exchange and financial markets are not well developed, capital control measures could be beneficial to ensure smooth functioning of a managed floating regime.
    Keywords: Exchange rate regime, Capital account, and Real exchange rate
    JEL: O11 F32 F41
    Date: 2006
  10. By: Giancarlo Corsetti; Luca Dedola; Sylvain Leduc
    Abstract: This paper develops a quantitative, dynamic, open-economy model which endogenously generates high exchange rate volatility, whereas a low degree of pass-through stems from both nominal rigidities (in the form of local currency pricing) and price discrimination. We model real exchange rate volatility in response to real shocks by reconsidering and extending two approaches suggested by the quantitative literature (one by Backus Kehoe and Kydland [1995], the other by Chari, Kehoe and McGrattan [2003]), within a common framework with incomplete markets and segmented domestic economies. Our model accounts for a variable degree of ERPT over different horizons. In the short run, we find that a very small amount of nominal rigidities - consistent with the evidence in Bils and Klenow [2004] - lowers the elasticity of import prices at border and consumer level to 27% and 13%, respectively. Remarkably, exchange rate depreciation worsens the terms of trade - in accord to the evidence stressed by Obstfeld and Rogo [2000]. In the long run, exchange-rate pass-through coefficients are also below one, as a result of price discrimination. The latter is an implication of distribution services, which makes the goods demand elasticity market specific.
    Keywords: international business cycle, exchange rate volatility, pass-through, international transmission, DSGE models
    JEL: F33 F41
    Date: 2005
  11. By: Bjørnland, Hilde C. (Dept. of Economics, University of Oslo); Hungnes, Håvard (Statistics Norway, Research Department.)
    Abstract: This paper addresses the purchasing power parity (PPP) puzzle for a commodity currency. In particular, we analyse the real exchange rate behaviour in Norway, which has a primary commodity (oil) that constitutes the majority of its exports. A substantial part of the literature on commodity currencies has found that, despite controlling for the effect of commodity prices, PPP does not hold in the long run. We show that once we also control for the effect of the interest rate differential in the real exchange rate relationship, the discrepancies from PPP are fully accounted for. Furthermore, with the interest rate differential included in the long run real exchange rate relationship, the real oil price plays only a minor role. Adjustment to equilibrium (half-lives) is also substantially reduced, taking no more than one year on average. Hence, contrary to earlier findings on commodity currencies, we have effectively removed the PPP puzzle.
    Keywords: Exchange rate; commodity currencies; real oil price; purchasing power parity; uncovered interest parity.
    JEL: C32 F31
    Date: 2005–12–20

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