Empirical exchange rate models of the seventies: Do they fit out of sample?

FIRST ARTICULATED by scholars of the ISalamanca school in sixteenth century Spain,1 purchasing power parity (PPP) is the disarmingly simple empirical proposition that, once converted to a common currency, national price levels should be equal. The basic idea is that if goods market arbitrage enforces broad parity in prices across a sufficient range of individual goods (the law of one price), then there should also be a high correlation in aggregate price levels. While few empirically literate economists take PPP seriously as a short-term proposition, most instinctively believe in some variant of purchasing power parity as an anchor for long-run real exchange rates. Warm, fuzzy feelings about PPP are not, of course, a substitute for hard evidence. There is today an enormous and evergrowing empirical literature on PPP, one that has arrived at a surprising degree of consensus on a couple of basic facts. First, at long last, a number of recent studies have weighed in with fairly persuasive evidence that real exchange rates (nominal exchange rates adjusted for differences in national price levels) tend toward purchasing power parity in the very long run. Consensus estimates suggest, however, that the speed of convergence to PPP is extremely slow; deviations appear to damp out at a rate of roughly 15 percent per year. Second, short-run deviations from PPP are large and volatile. Indeed, the one-month conditional volatility of real exchange rates (the volatility of deviations from PPP) is of the same order of magnitude as the conditional volatility of nominal exchange rates. Price differential volatility is surprisingly large even when one confines attention to relatively homogenous classes of highly traded goods. The purchasing power parity puzzle then is this: How can one reconcile the enormous short-term volatility of real exchange rates with the extremely slow rate at which shocks appear to damp out? Most explanations of short-term exchange rate volatility point to financial factors such as changes in portfolio preferences, short-term asset price bubbles, and monetary shocks (see, for example, Maurice Obstfeld and Rogoff forthcoming). Such shocks can have substantial effects on the real economy in the presence of sticky nominal wages and prices. I See Lawrence H. Officer (1982, ch. 3) for an extensive discussion of the origins of PPP theory; see also Dornbusch (1987).

/pdf/the-purchasing-power-parity-puzzle-2mj15yxf16.pdf

The Purchasing Power Parity Puzzle

This paper examines the hypothesis that the expected rate of return to speculation in the forward foreign exchange market is zero; that is, the logarithm of the forward exchange rate is the market's conditional expectation of the logarithm of the future spot rate. A new computationally tractable econometric methodology for examining restrictions on a k-step-ahead forecasting equation is employed. Using data sampled more finely than the forecast interval, we are able to reject the simple market efficiency hypothesis for exchange rates from the 1970s and the 1920s. For the modern experience, the tests are also inconsistent with several alternative hypotheses which typically characterize the relationship between spot and forward exchange rates.

https://www.jstor.org/stable/pdfplus/1833137.pdf

Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis

How internationally mobile is the world's supply of capital? Does capital flow among industrial countries to equalize the yield to investors? Alternatively, does the saving that originates in a country remain 'to be invested there? Or does the truth lie somewhere between these two extremes? The answers to these questions are not only important for understanding the international capital market but are also critical for analyzing a wide range of issues including the nation's optimal rate of saving and the incidence of tax changes. (This abstract was borrowed from another version of this item.)

/pdf/domestic-saving-and-international-capital-flows-3bqykct5pr.pdf

Domestic Saving and International Capital Flows

An optimum currency area refers to the ‘optimum’ geographical domain having as a general means of payments either a single common currency or several currencies whose exchange values are immutably pegged to one another with unlimited convertibility for both current and capital transactions, but whose exchange rates fluctuate in unison against the rest of the world. ‘Optimum’ is defined in terms of the macroeconomic goal of maintaining internal and external balance. Internal balance is achieved at the optimal trade-off point between inflation and unemployment (if such a trade-off really exists), and external balance involves both intra-area and inter-area balance of payments equilibrium.

Optimum Currency Areas

This paper deals with the determinants of the exchange rate and develops a monetary view (or more generally, an asset view) of exchange rate determination. The first part traces some of the doctrinal origins of approaches to the analysis of equilibrium exchange rates. The second part examines some of the empirical hypotheses of the monetary approach as well as some features of the efficiency of the foreign exchange markets. Special emphasis is given to the role of expectations in exchange rate determination and a direct observable measure of expectations is proposed. The direct measure of expectations builds on the information that is contained in data from the forward market for foreign exchange. The empirical results are shown to be consistent with the hypotheses of the monetary approach.

https://www.jstor.org/stable/pdfplus/3439924.pdf

A Monetary Approach To The Exchange Rate: Doctrinal Aspects And Empirical Evidence

Recent experience with flexible exchange rate systems has led to renewed interest in the operation of foreign exchange markets as reflected in many recent studies of the principal determinants of exchange rates. The 1970s witnessed the dramatic alteration of the international monetary system from a regime of pegged exchange rates which prevailed for about a quarter of a century (since the Bretton Woods conference) into a regime of flexible (though managed) rates. As a consequence of the emergence of the new legal and economic system traders, national governments and international organisations were confronted with new economic problems, choices and instruments. During the 1970s ex-change rates fluctuated widely and inflation rates accelerated. The international monetary system had to accommodate extraordinarily large oil-related shocks which affected trade flows in goods and assets. Huge oil payments had to be recycled. Uncertainties concerning future developments in international politics reached new heights and the prospects for the world economy got gloomier. These developments placed unprecedented pressures on the markets for foreign exchange as well as on other asset markets. They were associated with a large slide in the value of the US dollar, and resulted in speeding up the creation of new institutions like the European monetary system which provided the formal framework for the management of exchange rates among members.

Flexible Exchange Rates, Prices and the Role of ‘News’: Lessons from the 1970s

The first part of the paper traces the doctrinal origins of the purchasing power parity (PPP) doctrine and reviews the central issues of controversy. The second part is an empirical study covering the flexible exchange rates period of the 1920s. The empirical work examines the efficiency of foreign exchange markets, the absolute and the relative versions of PPP for alternative price indices, the homogeneity postulate, the relation between the short run and the long run, and the patterns of 'causality' between prices and exchange rates. The paper concludes with estimations of price equations and a discussion of the proper specification of PPP.

Purchasing Power Parity: Doctrinal Perspective and Evidence from the 1920s

This paper reviews and analyzes the empirical record of exchange rates and prices during the 1970's and the analysis is based on the experience of the Dollar/Pound, the Dollar/French Franc and the Dollar/DM exchange rates. Section 2 presents the evidence on PPP during the 1970's and contrasts it with the evidence from the 1920's -- a period during which the doctrine held up reasonably well. This analysis is relevant for assessing whether the flexible exchange rate system was successful in providing national economies with an added degree of insulation from foreign shocks, and whether it provided policymakers with an added instrument for the conduct of macroeconomic policy. The evidence regarding deviations from purchasing power parities is also relevant for determining whether there is a case for managed float. Section 3 attempts to explain what went wrong with the performance of the doctrine during the 1970's. It examines the hypothesis that the departures from PPP are a U.S. phenomenon, as well as the hypothesis that the departures are due to large changes in inter-sectoral relative price changes within the various economies. Given that the predictions of the simple versions of PPP do not hold up, section 4 proceeds in examining the question of whether national price levels have been independent of each other. Section 5 addresses the question of whether exchange rates and national price levels are comparable and whether in principle one should have expected them to be closely linked to each other. The main point that is being emphasized is that there is an important intrinsic difference between exchange rates and national price levels which stems from the basset market theory' of exchange rate determination. This theory implies that the exchange rate, like the prices of other assets, is much more sensitive to expectations concerning future events than national price levels and as a result, in periods which are dominated by news' which alter expectations, exchange rates are likely to be much more volatile than national price levels and departures from PPP are likely to be the rule rather than the exception. Finally, section 6 concludes the paper with some policy implications.

Jacob A. Frenkel

Papers

A Monetary Approach To The Exchange Rate: Doctrinal Aspects And Empirical Evidence

Flexible Exchange Rates, Prices and the Role of ‘News’: Lessons from the 1970s

Purchasing Power Parity: Doctrinal Perspective and Evidence from the 1920s

Purchasing Power Parity: Doctrinal Perspective and Evidence from the 1920s

The Collapse of Purchasing Power Parities during the 1970s