nep-ifn New Economics Papers
on International Finance
Issue of 2006‒11‒25
fifteen papers chosen by
Yi-Nung Yang
Chung Yuan Christian University

  1. Pricing-to-Market, the Interest-Rate Rule, and the Exchange Rate By Maurice Obstfeld
  2. Purchasing Power Parity: The Irish Experience Re-visited By Derek Bond; Michael J. Harrison; Edward J. O'Brien
  3. Unit Roots, Nonlinear Cointegration and Purchasing Power Parity By Alfred A. Haug; Syed A. Basher
  4. Incomplete information processing: a solution to the forward discount puzzle By Philippe Bacchetta; Eric van Wincoop
  5. Signaling currency crises in South Africa By Tobias Knedlik
  6. Pacific Island Countries--Possible Common Currency Arrangement By Christopher Browne; David William Harold Orsmond
  7. A Small Foreign Exchange Market with a Long-Term Peg: Barbados By Roland Craigwell; Travis Mitchell; DeLisle Worrell
  8. External Adjustment and Equilibrium Exchange Rate in Brazil By Claudio Paiva
  9. Using ARIMA Forecasts to Explore the Efficiency of the Forward Reichsmark Market: Austria-Hungary, 1876-1914 By Komlos, John; Flandreau, Marc
  10. The Obstinate Passion of Foreign Exchange Professionals: Technical Analysis By Menkhoff, Lukas; Taylor, Mark P.
  11. Euro-Dollar Real Exchange Rate Dynamics in an Estimated Two-Country Model: What Is Important and What Is Not By Pau Rabanal; Vicente Tuesta
  12. Exchange Rate Volatility and the Credit Channel in Emerging Markets: A Vertical Perspective By Caballero, Ricardo; Krishnamurthy, Arvind
  13. The U.S. current account deficit and the expected share of world output By Charles Engel; John H. Rogers
  14. One Market, One Money, One Price? By Allington, Nigel FB; Kattuman, Paul A; Waldmann, Florian A
  15. Fiscal Policies, External Deficits, and Budget Deficits By Michel Normandin

  1. By: Maurice Obstfeld
    Abstract: Even when the exchange-rate plays no expenditure-switching role, countries may wish to have flexible exchange rates in order to free the domestic interest rate as a stabilization tool. In a setting with nontraded goods, exchange-rate movements may also enhance international risk sharing.
    JEL: F41 F42
    Date: 2006–11
  2. By: Derek Bond (University of Ulster); Michael J. Harrison (Department of Economics, Trinity College); Edward J. O'Brien (European Central Bank)
    Abstract: This paper looks at issues surrounding the testing of purchasing power parity using Irish data. Potential difficulties in placing the analysis in an I(1)/I(0) framework are highlighted. Recent tests for fractional integration and nonlinearity are discussed and used to investigate the behaviour of the Irish exchange rate against the United Kingdom and Germany. Little evidence of fractionality is found but there is strong evidence of nonlinearity from a variety of tests. Importantly, when the nonlinearity is modelled using a random field regression, the data conform well to purchasing power parity theory, in contrast to the findings of previous Irish studies, whose results were very mixed.
    JEL: C22 F31 F41
    Date: 2006–11
  3. By: Alfred A. Haug (Department of Economics, York University); Syed A. Basher (Department of Economics, York University)
    Abstract: We test long¨Crun PPP within a general model of cointegration of linear and nonlinear form. Nonlinear cointegration is tested with rank tests proposed by Breitung (2001). We start with determining the order of integration of each variable in the model, applying relatively powerful DF¨CGLS tests of Elliott, Rothenberg and Stock (1996). Using monthly data from the post¨CBretton Woods era for G¨C10 countries, the evidence leads to a rejection of PPP for almost all countries. In several cases the price variables are driven by permanent shocks that differ from the ones that drive the exchange rate. Also, nonlinear cointegration cannot solve the PPP puzzle.
    Keywords: Purchasing power parity; unit roots; nonlinear cointegration
    JEL: C22 F40
    Date: 2003–01
  4. By: Philippe Bacchetta; Eric van Wincoop
    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 differential, is negatively related to the subsequent change in the exchange rate. This forward discount puzzle implies that excess returns on foreign currency investments are predictable. In this paper we investigate to what extent incomplete information processing can explain this puzzle. We consider two types of incompleteness: infrequent and partial information processing. We calibrate a two-country general equilibrium model to the data and show that incomplete information processing can fully match the empirical evidence. It can also account for several related empirical phenomena, including that of "delayed overshooting." We show that incomplete information processing is consistent both with evidence that little capital is devoted to actively managing short-term currency positions and with a small welfare gain from active portfolio management. The gain is small because exchange rate changes are very hard to predict. The welfare gain is easily outweighed by a small cost of active portfolio management.
    Keywords: Foreign exchange
    Date: 2006
  5. By: Tobias Knedlik
    Abstract: Currency crises episodes of 1996, 1998, and 2001 are used to identify common country specific causes of currency crises in South Africa. The paper identifies crises by the use of an Exchange Market Pressure (EMP) index as introduced by Eichengreen, Rose and Wyplosz (1996). It extends the Signals Approach introduced by Kaminsky and Reinhart (1996, 1998) by developing a composite indicator in order to measure the evolution of currency crisis risk in South Africa. The analysis considers the standard suspects from international currency crises and country specifics as identified by the Myburgh Commission (2002) and current literature as potentially relevant indicators.
    Keywords: signals approach, currency crises, South Africa
    JEL: E5 F3 G1
    Date: 2006–11
  6. By: Christopher Browne; David William Harold Orsmond
    Abstract: This paper examines the potential advantages and disadvantages of adopting a common currency arrangement among the six IMF member Pacific island countries that have their own national currency. These countries are Fiji, Papua New Guinea, Samoa, Solomon Islands, Tonga, and Vanuatu. The study explains that the present exchange rate regimes-comprising pegging to a basket of currencies for five countries and the floating arrangement for Papua New Guinea-have generally succeeded in avoiding inflationary, balance of payments, external debt, and financial system problems. The study concludes that adopting a common currency in the Pacific would require greater convergence of domestic policies and substantial strengthening of regional policies, which would take time to achieve.
    Keywords: Economic integration , regional currency arrangements , Pacific Island countries ,
    Date: 2006–10–24
  7. By: Roland Craigwell; Travis Mitchell; DeLisle Worrell
    Abstract: This paper is a first analysis of daily transactions in the foreign exchange market of Barbados, a small open economy that has had an unchanged peg to the U.S. dollar for over 30 years. As a result of the credibility of the peg, we expect that capital flows will respond to differentials between U.S. and comparable Barbadian interest rates and that this will result in uncovered interest parity, when allowance is made for market frictions and large discrete events. The results are consistent with this hypothesis about the motivation for foreign exchange transactions.
    Keywords: Foreign exchange , exchange rate , interest parity ,
    Date: 2006–10–31
  8. By: Claudio Paiva
    Abstract: This paper investigates the factors behind the significant improvement in Brazil's external accounts and wide fluctuations of the real exchange rate since the floating of the real in 1999. Particular attention is devoted to the strong appreciation of the real from 2003-05. Econometric estimates of of behavioral equilibrium exchange rate (BEER) model for Brazil show that most of this appreciation was an equilibrium response to improved economic fundamentals.
    Keywords: Equilibrium exchange rate , real exchange rate , current account ,
    Date: 2006–10–16
  9. By: Komlos, John; Flandreau, Marc
    Abstract: We explore the efficiency of the forward Reichsmark market in Vienna between 1876 and 1914. We estimate ARIMA models of the spot exchange rate in order to forecast the one-month-ahead spot rate. In turn we compare these forecasts to the contemporaneous forward rate, i.e., the market's forecast of the future spot rate. We find that shortly after the introduction of a shadow gold standard in the mid-1890s the forward rate became a considerably better predictor of the future spot rate than during the prior flexible exchange rate regime. Between 1907 and 1914 forecast errors were between a half and one-fourth of their pre-1896 level. This implies that the Austro-Hungarian Bank's policy of defending the gold value of the currency was successful in improving the efficiency of the foreign exchange market.
    Keywords: exchange rate; gold standard; ARIMA; efficiency
    JEL: F31 N23
    Date: 2006–11
  10. By: Menkhoff, Lukas; Taylor, Mark P.
    Abstract: Technical analysis involves the prediction of future exchange rate (or other asset-price) movements from an inductive analysis of past movements. A reading of the large literature on this topic allows us to establish a set of stylised facts, including the facts that technical analysis is an important and widely used method of analysis in the foreign exchange market and that applying certain technical trading rules over a sustained period may lead to significant positive excess returns. We then analyze four arguments that have been put forward to explain the continuing widespread use of technical analysis and its apparent profitability: that the foreign exchange market may be characterised by not-fully-rational behaviour; that technical analysis may exploit the influence of central bank interventions; that technical analysis may be an efficient form of information processing; and finally that it may provide information on non-fundamental influences on foreign exchange movements. Although all of these positions may be relevant to some degree, neither non-rationality nor official interventions seem to be widespread and persistent enough to explain the obstinate passion of foreign exchange professionals for technical analysis.
    Keywords: foreign exchange market, technical analysis, market microstructure
    JEL: F31
    Date: 2006–11
  11. By: Pau Rabanal; Vicente Tuesta
    Abstract: We use a Bayesian approach to estimate a standard two-country New Open Economy Macroeconomics model using data for the United States and the euro area, and we perform model comparisons to study the importance of departing from the law of one price and complete markets assumptions. Our results can be summarized as follows. First, we find that the baseline model does a good job in explaining real exchange rate volatility but at the cost of overestimating volatility in output and consumption. Second, the introduction of incomplete markets allows the model to better match the volatilities of all real variables. Third, introducing sticky prices in Local Currency Pricing improves the fit of the baseline model but does not improve the fit as much as introducing incomplete markets. Finally, we show that monetary shocks have played a minor role in explaining the behavior of the real exchange rate, while both demand and technology shocks have been important.
    Keywords: Real exchange rates , Bayesian estimation , model comparison , Euro , U.S. dollar , Real effective exchange rates , Economic models ,
    Date: 2006–08–03
  12. By: Caballero, Ricardo; Krishnamurthy, Arvind
    Abstract: Firms in emerging markets are exposed to severe financial frictions and credit constraints that are exacerbated by the sudden stop of capital inflows. Can monetary policy offset this external credit squeeze? We show that although this may be the case during moderate contractions (or in partial equilibrium), the expansionary effect of monetary policy vanishes during severe external crises. The exchange rate jumps to reduce the dollar value of domestic collateral until equilibrium in domestic financial markets is consistent with the external constraint. An expansionary monetary policy in this context raises the value of domestic collateral, but it exacerbates the exchange rate depreciation (beyond the standard interest parity effect) and has little effect on aggregate activity. However, there is a dynamic linkage between monetary policy and sudden stops. The anticipation of a dogged defense of the exchange rate worsens the consequences of sudden stops by distorting the private sector incentive to take precautions against these shocks. For similar general equilibrium reasons, dollarization of liabilities has limited impact during a sudden stop, but it has significant underinsurance consequences.
    JEL: G00 G0
    Date: 2005–01–25
  13. By: Charles Engel; John H. Rogers
    Abstract: We investigate the possibility that the large current account deficits of the U.S. are the outcome of optimizing behavior. We develop a simple long-run world equilibrium model in which the current account is determined by the expected discounted present value of its future share of world GDP relative to its current share of world GDP. The model suggests that under some reasonable assumptions about future U.S. GDP growth relative to the rest of the advanced countries--more modest than the growth over the past 20 years--the current account deficit is near optimal levels. We then explore the implications for the real exchange rate. Under some plausible assumptions, the model implies little change in the real exchange rate over the adjustment path, though the conclusion is sensitive to assumptions about tastes and technology. Then we turn to empirical evidence. A test of current account sustainability suggests that the U.S. is not keeping on a long-run sustainable path. A direct test of our model finds that the dynamics of the U.S. current account--the increasing deficits over the past decade--are difficult to explain under a particular statistical model (Markov-switching) of expectations of future U.S. growth. But, if we use survey data on forecasted GDP growth in the G7, our very simple model appears to explain the evolution of the U.S. current account remarkably well. We conclude that expectations of robust performance of the U.S. economy relative to the rest of the advanced countries is a contender--though not the only legitimate contender--for explaining the U.S. current account deficit.
    Keywords: Budget deficits ; Balance of trade
    Date: 2006
  14. By: Allington, Nigel FB; Kattuman, Paul A; Waldmann, Florian A
    Abstract: The introduction of the euro was intended to integrate markets within Europe further, after the implementation of the 1992 Single Market Project. We examine the extent to which this objective has been achieved, by examining the degree of price dispersion between countries in the euro zone, compared to a control group of EU countries outside the euro zone. We also establish the role of exchange rate risk in hampering arbitrage by estimating the euro effect for subgroups within the euro zone, utilizing differences among EU countries in participation in the Exchange Rate Mechanism. Our results, in contrast with previous empirical research, suggest robustly that the euro has had a significant integrating effect.
    JEL: G00 G0
    Date: 2005–03–21
  15. By: Michel Normandin (IEA, HEC Montréal)
    Abstract: This paper studies the effects of fiscal policies on external and budget deficits. From a tractable small open-economy, overlapping-generation model, the effects are measured by the responses of the external deficit to an increase in the budget deficit due to a tax-cut. The responses are positively affected by the birth rate and the degree of persistence of the budget deficit. Empirical results for the G7 countries over the post-1975 period reveal that the values of birth rate are small for all, but one, countries; but the responses of external and budget deficits are substantial and persistent for most countries. In particular, the fiscal policy has the most important effects on the external deficits for Canada, Japan, and the United States; somewhat smaller impacts for France, Germany, and the United Kingdom; and negligible effects for Italy.
    Keywords: Agents’ superior information; birth rate; impact and dynamic responses; G7 Countries; orthogonality restrictions.
    JEL: E62 F32 F41
    Date: 2006–05

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