nep-ifn New Economics Papers
on International Finance
Issue of 2006‒04‒22
fifteen papers chosen by
Yi-Nung Yang
Chung Yuan Christian University

  1. The Forward Exchange Rate Bias Puzzle: Evidence from New Cointegration Tests By Raj Aggarwal; Brian M. Lucey; Sunil K. Mohanty
  2. Rational Inattention: A Solution to the Forward Discount Puzzle By Philippe Bacchetta; Eric van Wincoop
  3. Arbitrage, Covered Interest Parity and Long-Term Dependence between the US Dollar and the Yen By Peter G. Szilagyi; Jonathan A. Batten
  4. Exchange-Rate Pass-Trough at the Product Level By Guillaume Gaulier; Amina Lahreche-Revil; Isabelle Mejean
  5. Macroeconomic Regime Switches and Speculative Attacks By Bartosz Mackowiak
  6. Currency Areas and Monetary Coordination By Qing Liu; Shouyong Shi
  7. The U.S. Current Account Deficit: Gradual Correction or Abrupt Adjustment? By Sebastian Edwards
  8. A Portfolio Theory of International Capital Flows By Michael B. Devereux; Makoto Saito
  9. Managing Exchange Rate Volatility: A Comparative Counterfactual Analysis of Singapore 1994 to 2003 By Peter Wilson; Henry Ng Shang Ren
  10. Real Exchange Rate Adjustment In European Transition Countries By Maican, Florin G.; Sweeney, Richard J.
  11. The Relationship Between Exchange Rates and Inflation Targeting Revisited By Sebastian Edwards
  12. The Chinese Yuan after the Chinese Exchange Rate System Reform By Eiji Ogawa; Michiru Sakane
  13. The Impact of Foreign Interest Rates on the Economy: The Role of the Exchange Rate Regime By Jay C. Shambaugh; Julian di Giovanni
  14. Exchange Rate Changes and Inflation in Post-Crisis Asian Economies: VAR Analysis of the Exchange Rate Pass-Through By Takatoshi Ito; Kiyotaka Sato
  15. Structural Determinants of the Exchange-Rate Pass-Through By Guillaume Gaulier; Amina Lahreche-Revil; Isabelle Mejean

  1. By: Raj Aggarwal; Brian M. Lucey; Sunil K. Mohanty
    Abstract: An important puzzle in international finance is the failure of the forward exchange rate to be a rational forecast of the future spot rate. It has often been suggested that this puzzle may be resolved by using better statistical procedures that correct for both non-stationarity and nonnormality in the data. We document that even after accounting for non-stationarity, nonnormality, and heteroscedasticity using parametric and non-parametric tests on data for over a quarter century, US dollar forward rates for horizons ranging from one to twelve months for the major currencies, the British pound, Japanese yen, Swiss franc, and the German mark, are generally not rational forecasts of future spot rates. These findings of non-rationality in forward exchange rates for the major currencies continue to be puzzling especially as these foreign exchange markets are some of the most liquid asset markets with very low trading costs.
    Keywords: flight-to-quality, contagion, multivariate GARCH
    JEL: F31 G14 F47 G15
    Date: 2006–04–05
  2. By: Philippe Bacchetta (University of Lausanne, Studienzentrum Gerzensee and CEPR); Eric van Wincoop (University of Virginia)
    Abstract: The uncovered interest rate parity equation is the cornerstone of most models in international macro. However, this equation does not hold empirically since the forward discount, or interest rate dierential, is negatively related to the subsequent change in the exchange rate. This forward discount puzzle is one of the most extensively researched areas in international nance. It implies that excess returns on foreign currency investments are predictable. In this paper we propose a new explanation for this puzzle based on rational inattention. We develop a model where investors face a cost of collecting and processing information. Investors with low information processing costs trade actively, while other investors are inattentive and trade infrequently. We calibrate the model to the data and show that (i) inattention can account for most of the observed predictability of excess returns in the foreign exchange market, (ii) the benet from frequent trading is relatively small so that few investors choose to be attentive, (iii) average expectational errors about future exchange rates are predictable in a way consistent with survey data for market participants, and (iv) the model can account for the puzzle of delayed overshooting of the exchange rate in response to interest rate shocks.
    Date: 2005–09
  3. By: Peter G. Szilagyi; Jonathan A. Batten
    Abstract: Using a daily time series from 1983 to 2005 of currency prices in spot and forward USD/Yen markets and matching equivalent maturity short term US and Japanese interest rates, we investigate the sensitivity over the sample period of the difference between actual prices in forward markets to those calculated from short term interest rates. According to a fundamental theorem in financial economics termed covered interest parity (CIP) the actual and estimated prices should be identical once transaction and other costs are accommodated. The paper presents four important findings: First, we find evidence of considerable variation in CIP deviations from equilibrium that tends to be one way and favours those market participants with the ability to borrow US dollars (and subsequently lend yen). Second, these deviations have diminished significantly and by 2000 have been almost eliminated. We attribute this to the effects of electronic trading and pricing systems. Third, regression analysis reveals that interday negative changes in spot exchange rates, positive changes in US interest rates and negative changes in yen interest rates generally affect the deviation from CIP more than changes in interday volatility. Finally, the presence of long-term dependence in the CIP deviations over time is investigated to provide an insight into the equilibrium dynamics. Using a local Hurst exponent – a statistic used in fractal geometry - we find episodes of both positive and negative dependence over the various sample periods, which appear to be linked to episodes of dollar decline/yen appreciation, or vice versa. The presence of negative dependence is consistent with the actions of arbitrageurs successfully maintaining the long-term CIP equilibrium. Given the time varying nature of the deviations from equilibrium the sample period under investigation remains a critical issue when investigating the presence of longterm dependence.
    Keywords: Hurst exponent; Efficient market hypothesis; covered interest parity, arbitrage
    JEL: C22 C32 E31 F31
    Date: 2006–04–05
  4. By: Guillaume Gaulier; Amina Lahreche-Revil; Isabelle Mejean
    Abstract: This paper uses a detailed database to investigate exchange-rate pass-through at the product level, for a large number of countries. Since the database provides harmonized trade flows, pass-through in both export and import prices can be investigated consistently. The empirical analysis suggests that pricing behaviors are dichotomic: while pass-through is complete in 30 to 40% of sectors, there is significant pricing-to-market in the remaining ones. The average long-run pass-through coefficient is nevertheless quite high, close to 80% on average. This result however hides a strong heterogeneity of pass-through behaviors across sectors and exporting countries, and to a lesser extent across importers. Trying to disentangle composition effects from structural factors, the analysis suggests that a large part of cross-country differences is attributable to composition effects. Still, the pass-through is on average higher i) in volatile environments, ii) in less developed countries, iii) in little integrated markets.
    Keywords: Pass-through; pricing-to-market; product-level analysis; macroeconomic determinants; prices; sectors
    JEL: F12 F31 F41
    Date: 2006–02
  5. By: Bartosz Mackowiak
    Abstract: This paper explains a currency crisis as an outcome of a switch in how monetary policy and fiscal policy are coordinated. The paper develops a model of an open economy in which monetary policy starts active, fiscal policy starts passive and, in a particular state of nature, monetary policy switches to passive and fiscal policy switches to active. The probability of the regime switch is endogenous and changes over time together with the state of the economy. The regime switch is preceded by a sharp increase in interest rates and causes a jump in the exchange rate. The model predicts that currency composition of public debt affects dynamics of macroeconomic variables. Furthermore, the model is consistent with evidence from recent currency crises, in particular small seigniorage revenues.
    Keywords: Coordination of monetary policy and fiscal policy, policy regime switch, currency crisis, speculative attack, fiscal theory of the price level
    JEL: E52 E61 F33
    Date: 2006–04
  6. By: Qing Liu; Shouyong Shi
    Abstract: In this paper we integrate the recent development in monetary theory with international finance, in order to examine the coordination between two currency areas in setting long-run inflation. The model determines the value of each currency and the size of each currency area without requiring buyers to use a particular currency to buy a country's goods. We show that the two countries inflate above the Friedman rule in a non-cooperative game. Coordination between the two areas reduces inflation to the Friedman rule, increases consumption, and improves welfare of both countries. This gain from coordination increases as the two areas become more integrated in trade. These results arise from the new features of the model, such as the deviations from the law of one price and the extensive margin of trade. To illustrate these new features, we show that introducing a direct tax on foreign holdings of a currency does not eliminate a country's incentive to inflate, while it does in traditional models.
    Keywords: Exchange rates; Currency areas; Coordination
    JEL: F41 E40
  7. By: Sebastian Edwards
    Abstract: In this paper I use a large multi-country data set to analyze the determinants of abrupt and large “current account reversals.” The results from a variance-component probit model indicate that the probability of experiencing a major current account reversal is positively affected by larger current account deficits, lower prices of exports relative to imports, and expansive monetary policies. On the other hand, this probability is lower for more advanced countries, and for countries with flexible exchange rates. An analysis of the marginal effects of current account deficits and of the predicted probability of reversal indicates that both have increased significantly for the U.S. since 1999. However, the level of this probability is still on the low side. I estimate that the predicted probability of a current account reversal in the U.S. has increased from 1.7% in 1999, to 14.9% in 2006.
    JEL: F02 F43 O11
    Date: 2006–04
  8. By: Michael B. Devereux; Makoto Saito
    Abstract: This paper constructs a model in which the currency composition of national portfolios is an essential element in facilitating capital ‡ows between countries. In a two country environment, each country chooses optimal nominal bond portfolios in face of real and nominal risk.Current account deficits are financed by increases in domestic currency debt, but balanced by increases in foreign currency credit. This is combined with an evolution of risk-premiums such that the rate of return on the debtor country’s gross liabilities is lower than the return on its gross assets. This ensures stability of the world wealth distribution.
    Date: 2006–04–05
  9. By: Peter Wilson (Department of Economics, National University of Singapore 1 Arts Link, Singapore); Henry Ng Shang Ren
    Abstract: The objective of this paper is see how well Singapore’s exchange rate regime has coped with exchange rate volatility before and after the Asian financial crisis by comparing the performance of Singapore’s actual regime in minimising the volatility of the nominal effective exchange rate (NEER) and the bilateral rate against the US$ against some counterfactual regimes and the corresponding performance of eight other East Asian countries. In contrast to previous counterfactual exercises, such as Williamson (1998a) and Ohno (1999) which compute the weights for effective exchange rates on the basis of simple bloc aggregates, we apply a more disaggregated methodology using a larger number of trade partners. We also utilize ARCH/GARCH techniques to obtain estimates of heteroskedastic variances to better capture the time-varying characteristics of volatility for the actual and simulated exchange rate regimes. Our findings confirm that Singapore’s managed floating exchange rate system has delivered relatively low currency volatility. Although there are gains in volatility reduction for all countries in the sample from the adoption of either a unilateral or common basket peg, particularly post-crisis, these gains are relatively low for Singapore, largely because low actual volatility. Finally, there are additional gains for nondollar peggers from stabilizing intra-EA exchange rates against the dollar if they were to adopt a basket peg, especially post-crisis, but the gains for Singapore are again relatively modest.
    Keywords: East Asia, exchange rates, counterfactuals.
    JEL: F31 F33 F36
  10. By: Maican, Florin G. (Department of Economics, School of Business, Economics and Law, Göteborg University); Sweeney, Richard J. (McDonough School of Business, Georgetown University)
    Abstract: This paper presents unit-root test results for real exchange rates in ten Central and Eastern European transition countries during 1993:01-2003:12. Because of the shift from controlled to market economies and the accompanying crises, failed policy regimes and changes in exchange rate regimes, appropriate tests in transition countries require allowing for both structural changes and outliers. In both single-equation tests and panel tests with SUR techniques, the data reject the unit-root null for the CEE countries. Accounting for structural breaks and outliers gives much faster mean-reversion speeds than otherwise. <p>
    Keywords: Purchasing power parity; real exchange rate; Monte Carlo; unit root; transition countries; panel data
    JEL: C15 C22 C32 C33 E31 F31
    Date: 2006–02–14
  11. By: Sebastian Edwards
    Abstract: This paper deals with the relationship between inflation targeting and exchange rates. I address three specific issues: first, I analyze the effectiveness of nominal exchange rates as shock absorbers in countries with inflation targeting. This issue is closely related to the magnitude of the "pass-through" coefficient. Second, I investigate whether exchange rate volatility is different in countries with an inflation targeting regime than in countries with alternative monetary policy arrangements. And third, I discuss whether the exchange rate should play a role in determining the monetary policy stance under inflation targeting. An alternative way of posing this question is whether the exchange rate should have an independent role in an open economy Taylor rule.
    JEL: F02 F43
    Date: 2006–04
  12. By: Eiji Ogawa; Michiru Sakane
    Abstract: In this paper, we investigate the actual exchange rate policy conducted by the Chinese government after the Chinese exchange rate system reform on July 21 2005. Also, we investigate long-run effect (Balassa-Samuelson effect) on the Chinese yuan. We found that the Chinese government had a statistically significant but small change in exchange rate policy during our sample period to January 25, 2006. It is not identified that the Chinese monetary authority is adopting the currency basket system because the change is too small in the economic sense. On one hand, higher growth rate of productivity will appreciate the Chinese yuan in terms of the US dollar and the Japanese yen while higher growth rates of productivity in Chinese tradable good sector tend to give the Balassa-Samuleson effect, that is undervaluation bias, to the Chinese yuan.
    Date: 2006–04
  13. By: Jay C. Shambaugh; Julian di Giovanni
    Abstract: It is often argued that small economies are affected by conditions in large countries. This paper explores the connection between interest rates in major industrial countries and annual real output growth in other countries. The results show that high large-country interest rates have a contractionary effect on annual real GDP growth in the domestic economy, but that this effect is centered on countries with fixed exchange rates. The paper then examines the potential channels through which large-country interest rates affect small economies. The direct monetary policy channel is the most likely channel when compared with other possibilities, such as a general capital market effect or a trade effect.
    JEL: F3 F4
    Date: 2006–04–05
  14. By: Takatoshi Ito; Kiyotaka Sato
    Abstract: The pass-through effects of exchange rate changes on the domestic prices in the East Asian countries are examined using a VAR analysis including several price indices and domestic macroeconomic variables as well as the exchange rate. Results from the VAR analysis show that (1) the degree of exchange rate pass-through to import prices was quite high in the crisis-hit countries; (2) the pass-through to CPI was generally low, with a notable exception of Indonesia: and (3) in Indonesia, both the impulse response of monetary policy variables to exchange rate shocks and that of CPI to monetary policy shocks are positive, large and statistically significant. Thus, Indonesia's accommodative monetary policy as well as the high degree of the CPI responsiveness to exchange rate changes was important factors that resulted in the spiraling effects of domestic price inflation and sharp nominal exchange rate depreciation in the post-crisis period.
    Date: 2006–04
  15. By: Guillaume Gaulier; Amina Lahreche-Revil; Isabelle Mejean
    Abstract: Recent papers have tried to explain incomplete pass-through observed at the aggregate level by various microeconomic behaviors. This paper assesses some of these explanations, using product-level estimates of pricing-to-market coefficients obtained from a new database of bilateral international trade that covers more than 5,000 products and 130 countries. Half of the industries are found to exhibit pricing-to-market, but the magnitude of the pass-through is shown to vary widely across sectors, even at the most detailed level. Pricing-to-market is then shown to be higher in markets where arbitrage is made easier by the existence of referenced prices, and for final consumption goods. Moreover, competitive pressures faced by exporting firms are shown to affect pass-through decisions as well: firms tend to price to market all the less that their market share in the destination market is large, and that the destination markets are small or concentrated.
    Keywords: Pass-through determinants; product-level analysis; panel data; oligopolistic competition; oligopolies; competition; panel; prices; exchange rate
    JEL: F1 F4
    Date: 2006–02

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