nep-ifn New Economics Papers
on International Finance
Issue of 2009‒02‒07
nine papers chosen by
Yi-Nung Yang
Chung Yuan Christian University

  1. A new solution to the Purchasing Power Parity puzzles: Risk-aversion, exchange rate uncertainty and the Law of One Price By Arghyrou, Michael G; Gregoriou, Andros; Pourpourides, Panayiotis M.
  2. Estimating Exchange Rate Equations Using Estimated Expectations By Fair, Ray C.
  3. New Estimation of China’s Exchange Rate Regime By Jeffrey A. Frankel
  4. Revisiting the importance of non-tradable goods' prices in cyclical real exchange rate fluctuations By Ida Wolden Bache; Kjersti Næss; Kjersti Næss; Tommy Sveen
  5. Resolving the unbiasedness puzzle in the foreign exchange market By Daniel L. Thornton
  6. The Taylor rule and forecast intervals for exchange rates By Jian Wang; Jason J. Wu
  7. Exchange Rate Volatility and Investment, A Panel Data Cointegration Approach By Diallo , Ibrahima Amadou
  8. Understanding forecast failure in ESTAR models of real exchange rates By Buncic, Daniel
  9. Current account benchmarks for central and eastern Europe - a desperate search? By Michele Ca’ Zorzi; Alexander Chudik; Alistair Dieppe

  1. By: Arghyrou, Michael G (Cardiff Business School); Gregoriou, Andros; Pourpourides, Panayiotis M. (Cardiff Business School)
    Abstract: Market imperfections are the main explanation offered by the existing literature for violations of the Law of One Price and Purchasing Power Parity (PPP) among industrialised countries. We argue that even in perfectly frictionless markets risk aversion driven by exchange rate uncertainty causes a wedge between the domestic and foreign price of a totally homogeneous good. We test this hypothesis on a unique data set from a real-world market with minimum imperfections; and aggregate data for bilateral US dollar exchange rates in the G7 area. The empirical findings validate our hypothesis, thus providing a new, additional to market-imperfections, solution to the PPP puzzles.
    Keywords: Law of one price; purchasing power parity; risk aversion; exchange rate uncertainty
    JEL: F31 F41
    Date: 2009–01
  2. By: Fair, Ray C. (Yale U)
    Abstract: This paper takes a somewhat different approach from the recent literature in estimating exchange rate equations. It assumes uncovered interest rate parity and models how expectations are formed. Agents are assumed to base their expectations of future interest rates and prices, which are needed in the determination of the exchange rate, on predictions from a ten equation VAR model. The overall model is estimated by FIML under model consistent expectations. The model generally does better than the random walk model, and its properties are consistent with observed effects on exchange rates from surprise interest rate and price announcements. Also, the focus on expectations is consistent with the large observed short run variability of exchange rates.
    JEL: F31
    Date: 2008–01
  3. By: Jeffrey A. Frankel
    Abstract: The paper updates the answer to the question: what precisely is the exchange rate regime that China has put into place since 2005, when it announced a move away from the dollar peg? Is it a basket anchor with the possibility of cumulatable daily appreciations, as was announced at the time? We apply to this question a new approach to estimating countries' de facto exchange rate regimes, a synthesis of two techniques. One is a technique that has been used in the past to estimate implicit de facto currency weights when the hypothesis is a basket peg with little flexibility. The second is a technique used to estimate the de facto degree of exchange rate flexibility when the hypothesis is an anchor to the dollar or some other single major currency. Since the RMB and many other currencies today purportedly follow variants of Band-Basket-Crawl, it is important to have available a technique that can cover both dimensions, inferring weights and inferring flexibility. The synthesis adds a variable representing "exchange market pressure" to the currency basket equation, whereby the degree of flexibility is estimated at the same time as the currency weights. This approach reveals that by mid-2007, the RMB basket had switched a substantial part of the dollar's weight onto the euro. The implication is that the appreciation of the RMB against the dollar during this period was due to the appreciation of the euro against the dollar, not to any upward trend in the RMB relative to its basket.
    JEL: F31
    Date: 2009–02
  4. By: Ida Wolden Bache (Norges Bank (Central Bank of Norway)); Kjersti Næss (Norges Bank (Central Bank of Norway)); Kjersti Næss (Norges Bank (Central Bank of Norway)); Tommy Sveen (Norges Bank (Central Bank of Norway))
    Abstract: In an influential paper Engel (1999. Accounting for U.S. Real Exchange Rate Changes, Journal of Political Economy 107, 507-538) argues that essentially all the flctuations in the real exchange rate can be attributed to fluctuations in the relative price of traded goods, and that only a small part of the fluctuations can be attributed to changes in the relative price of non-tradables. We instead decompose the real exchange rate into three components: the relative price of traded goods at-the-dock, the difference in the relative price of non-traded to traded goods and the difference in the wedge between retail prices of traded goods and the prices of traded goods at-the-dock. Using data on US bilateral real exchange rates we find that the fluctuations in the relative wedge between retail prices and traded goods prices at-the-dock account for on average between 30 and 70 percent of the movements in the real exchange rate. These findings suggest that the relationship between traded goods prices at-the-dock and retail prices of traded goods is key to understanding real exchange rate fluctuations.
    Keywords: Real exchange rates
    JEL: F31 F41
    Date: 2009–01–30
  5. By: Daniel L. Thornton
    Abstract: An unresolved puzzle in the empirical foreign exchange literature is that tests of forward rate unbiasedness using the forward rate and forward premium equations yield markedly different conclusions about the unbiasedness of the forward exchange rate. This puzzle is resolved by showing that because of the persistence in exchange rates, estimates of the slope coefficient from the forward premium equation are extremely sensitive to small violations of the null hypothesis of the type and magnitude that are likely to exist in the real world. Moreover, contrary to suggestions in the literature and common practice, the forward premium equation does not necessarily provide a better test of unbiasedness than the forward rate equation.
    Keywords: Foreign exchange
    Date: 2009
  6. By: Jian Wang; Jason J. Wu
    Abstract: This paper attacks the Meese-Rogoff (exchange rate disconnect) puzzle from a different perspective: out-of-sample interval forecasting. Most studies in the literature focus on point forecasts. In this paper, we apply Robust Semi-parametric (RS) interval forecasting to a group of Taylor rule models. Forecast intervals for twelve OECD exchange rates are generated and modified tests of Giacomini and White (2006) are conducted to compare the performance of Taylor rule models and the random walk. Our contribution is twofold. First, we find that in general, Taylor rule models generate tighter forecast intervals than the random walk, given that their intervals cover out-of-sample exchange rate realizations equally well. This result is more pronounced at longer horizons. Our results suggest a connection between exchange rates and economic fundamentals: economic variables contain information useful in forecasting the distributions of exchange rates. The benchmark Taylor rule model is also found to perform better than the monetary and PPP models. Second, the inference framework proposed in this paper for forecast-interval evaluation, can be applied in a broader context, such as inflation forecasting, not just to the models and interval forecasting methods used in this paper.
    Date: 2009
  7. By: Diallo , Ibrahima Amadou
    Abstract: This paper examines the link between the real exchange rate volatility and domestic investment by using the panel data cointegration techniques. In the first part of the paper, we study the theoretical link between the exchange rate, its volatility and the investment in a small open economy. The model shows that the effects of exchange rate volatility on investment are nonlinear. In the second part, we examine the empirical link between the exchange rate volatility and the investment. The results illustrate that the exchange rate volatility has a strong negative impact on investment. This outcome is robust in low income and middle income countries, and by using an alternative measurement of exchange rate volatility
    Keywords: Exchange rate volatility; Investment; Appreciation; Depreciation; Panel data cointegration; Dynamic Optimization; Capital goods; Expectations
    JEL: O11 O24 O16 O57 O19
    Date: 2008
  8. By: Buncic, Daniel
    Abstract: The forecast performance of the empirical ESTAR model of Taylor et al. (2001) is examined for 4 bilateral real exchange rate series over an out-of-sample evaluation period of nearly 12 years. Point as well as density forecasts are evaluated relative to a simple AR(1) specification, considering horizons up to 22 steps head. The results of this study suggest that no forecast gains over a simple AR(1) model exist at any of the forecast horizons that are considered, regardless of whether point or density forecasts are used. Using simulation and non-parametric techniques in conjunction with graphical methods, this study shows that the non-linearity in the point forecasts of the ESTAR model decrease as the forecast horizon increases. Multiple steps ahead density forecasts of the ESTAR model are approximately normal looking, with no signs of skewness or bimodality. For an applied forecaster, there do not appear to exist any gains in using the non-linear ESTAR model over a simple AR(1) specification.
    Keywords: Purchasing power parity; regime modelling; non-linear real exchange rate models; ESTAR; forecast evaluation; density forecasts; non-parametric methods.
    JEL: C53 C52 C22 F47 F31
    Date: 2009–02–03
  9. By: Michele Ca’ Zorzi (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Alexander Chudik (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Alistair Dieppe (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper examines two competing approaches for calculating current account benchmarks, i.e. the external sustainability approach á la Lane and Milesi-Ferretti (LM) versus the structural current accounts literature (SCA) based on panel econometric techniques. The aim is to gauge the medium term adjustment in current account positions that may be required in some central and eastern European countries. As regards the LM approach, we show how the outcome is especially sensitive to (i) the normative choice for external indebtedness and (ii) the decision to exclude the foreign direct investment subcomponent from the NFA aggregate. Turning our search to the SCA approach, we assess its sensitivity to model and parameter uncertainty by setting different selection criteria to choose amongst the over 8000 possible combinations of fundamentals. Furthermore, to test the robustness of our findings we combine all models, attaching to each a probability (Bayesian Averaging of Classical Estimates). We show both the LM and SCA methodologies are not immune from severe drawbacks and conceptual difficulties. Nevertheless pulling together the results of both approaches point to the countries that may need a current account adjustment over a medium term horizon. JEL Classification: C11, C33, F15, F32, F34, F41, O52.
    Keywords: Current account, capital flows, financial integration, central and eastern Europe, panel data, model uncertainty, model combination.
    Date: 2009–01

This nep-ifn issue is ©2009 by Yi-Nung Yang. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.