Showing papers on "Exchange rate published in 1994"

Exchange rate dynamics redux

Abstract: We develop an analytically tractable two-country model that marries a full account of global macroeconomic dynamics to a supply framework based on monopolistic competition and sticky nominal prices. The model offers simple and intuitive predictions about exchange rates and current accounts that sometimes differ sharply from those of either modern flexible-price intertemporal models or traditional sticky-price Keynesian models. Our analysis leads to a novel perspective on the international welfare spillovers due to monetary and fiscal policies.

Firm Valuation, Earnings Expectations, and the Exchange‐Rate Exposure Effect

Abstract: Consistent with previous research, we fail to find a significant correlation between the abnormal returns of our sample firms with international activities and changes in the dollar. We investigate the possibility that this failure is due to mispricing. Lagged changes in the dollar are a significant variable in explaining current abnormal returns of our sample firms, suggesting that mispricing does occur. A simple trading strategy based upon these results generates significant abnormal returns. Corroborating evidence from returns around earnings announcements as well as errors in analysts' forecasts of earnings is also provided. IT IS A WIDELY held view that exchange rate movement should affect the value of a firm. Standard economic analysis implies that the profitability and value of most U.S. firms with foreign sales or operations abroad should increase (decrease) with an unexpected depreciation (appreciation) of the dollar as expected foreign currency cash flows translate into larger (smaller) U.S.

Sources of Real Exchange Rate Fluctuations: How Important are Nominal Shocks?

Abstract: This paper investigates empirically and attempts to identify the sources of real exchange rate fluctuations since the collapse of Bretton Woods. The paper's first two sections survey and extend earlier, non-structural empirical work on this subject by Campbell and Clarida (1987), Meese and Rogoff (1988), and Cumby and Huizinga (1990). The paper's main contribution is to build and estimate a three equation open macro model in the spirit of Dornbusch (1976) and Obstfeld (1985) and to identify the model's structural shocks - to demand, supply, and money -using the approach pioneered by Blanchard and Quah (1989). For two of the four countries we study, Germany and Japan, our structural estimates imply that monetary shocks, to money supply as well as to the demand for real money balances, explain a substantial amount of the variance of real exchange rates relative to the dollar. We find that demand shocks, to national saving and investment, explain the majority of the variance in real exchange rate fluctuations, while supply shocks explain very little. The model's estimated short run dynamics are strikingly consistent with the predictions of the simple textbook Mundell-Fleming model.

The Logic of Currency Crises

Abstract: Once one recognizes that governments borrow international reserves and exercise other policy options to defend fixed exchange rates during currency crises, the question arises: What factors determine a government's decision to abandon a currency peg or hang on? In a setting of purposeful action by the authorities, the possibility of self-fulfilling crises becomes important. Speculative anticipations depend on conjectured government responses, which depend, in turn, on how price changes that are themselves fueled by expectations affect the government's economic and political positions. The circular dynamic implies a potential for crises that need not have occurred, but that do because market participants expect them to. In contrast to this picture, most previous literature on balance-of- payments crises ignores the response of government behavior to markets. That literature, I argue, throws little light on events such as the European Exchange Rate Mechanism collapse of 1992-93. This paper then presents two different models in which crisis and realignment result from the interaction of rational private economic actors and a government that pursues well-defined policy goals. In both, arbitrary expectational shifts can turn a fairly credible exchange-rate peg into a fragile one.

Puzzles in International Financial Markets

Abstract: This paper presents a survey of two basic puzzles in international finance. The first puzzle is the `predictable excess return puzzle.' The returns on foreign currency deposits relative to domestic currency deposits should be equalized based upon uncovered interest parity. However, not only do researchers find that deviations from uncovered interest parity are predictable ex ante, but their variance exceeds the variance in expected exchange rate changes. In the paper, I describe different explanations of this phenomenon including the view that excess returns are driven by a foreign exchange risk premium, peso problems or learning, and market inefficiencies. While the research to date has been able to better define the `predictable excess return puzzle' and to suggest the most likely directions for future progress, no one explanation has provided a full answer to the puzzle. The second puzzle is the `home bias puzzle.' Empirical evidence shows that domestic residents do not diversify sufficiently into foreign stocks. This evidence is clear whether looking at models based on portfolio holdings or outcomes of consumption realizations across countries. In this paper, I examine several possible explanations including non-traded goods and market inefficiencies, although even after considering these possibilities, the puzzle remains.

Perspectives on PPP and long-run real exchange rates

Abstract: This paper reviews the large and growing literature which tests PPP and other models of the long-run real exchange rate. We distinguish three different stages of PPP testing and focus on what has been learned from each. The most important overall lesson has been that the real exchange rate appears stationary over sufficiently long horizons. Simple, univariate random walk specifications can be rejected in favor of stationary alternatives. However, we argue that multivariate tests, which ask whether any linear combination of prices and exchange rates are stationary, have not necessarily provided meaningful rejections of nonstationarity. We also review a number of other theories of the long run real exchange rate -- including the Balassa-Samuelson hypothesis -- as well as the evidence supporting them. We argue that the persistence of real exchange rate movements can be generated by a number of sensible models and that Balassa- Samuelson effects seem important, but mainly for countries with widely disparate levels of income of growth. Finally, this paper presents new evidence testing the law of one price on 200 years of historical commodity price data for England and France, and uses a century of data from Argentina to test the possibility of sample-selection bias in tests of long-run PPP.

Estimating equilibrium exchange rates

Abstract: The problems of exchange rate misalignments and the resulting payments imbalances have plagued the world economy for decades. At the Louvre Accord of 1987 the Group of Five industrial countries adopted a system of reference ranges for exchange rate management, influenced by proposals of C. Fred Bergsten and John Williamson for a target zone system. The reference range approach has, however, been operated only intermittently and half-heartedly, and questions continue to be raised in policy and scholarly circles about the design and operation of a full-fledged target zone regime. This collection of essays by leading international economists explores one crucial issue in the design of a target zone system: the problem of calculating the fundamental equilibrium exchange rate (FEER). Williamson contributes an overview of the policy and analytic issues and a second essay on his own calculations. Other contributors discuss the conceptual and empirical issues involved in their own approaches to estimating equilibrium rates. Stanley Black provides a concluding appraisal of the state of the art.

Perspectives on PPP and Long-Run Real Exchange Rates

Abstract: This paper reviews the large and growing literature which tests PPP and other models of the long-run real exchange rate. We distinguish three different stages of PPP testing and focus on what has been learned from each. The most important overall lesson has been that the real exchange rate appears stationary over sufficiently long horizons. Simple, univariate random walk specifications can be rejected in favor of stationary alternatives. However, we argue that multivariate tests, which ask whether any linear combination of prices and exchange rates are stationary, have not necessarily provided meaningful rejections of nonstationarity. We also review a number of other theories of the long run real exchange rate -- including the Balassa-Samuelson hypothesis -- as well as the evidence supporting them. We argue that the persistence of real exchange rate movements can be generated by a number of sensible models and that Balassa- Samuelson effects seem important, but mainly for countries with widely disparate levels of income of growth. Finally, this paper presents new evidence testing the law of one price on 200 years of historical commodity price data for England and France, and uses a century of data from Argentina to test the possibility of sample-selection bias in tests of long-run PPP.

Yen Bloc or Dollar Bloc? Exchange Rate Policies of the East Asian Economies

Abstract: One finds evidence of regional trading blocs, even after correcting bilateral trade flows for the influence of distance, GNPs, and other economic variables (which most other studies have not done). In this paper we also find a role for bilateral exchange rate variability in the equation. Some will suggest that the bias toward intra-regional trade is increasing in East Asia, that the yen is playing a greater role in the region, and that a movement by some Asian countries toward the yen and away from the dollar is a contributing factor to the diversion of trade flows. We find no evidence to support this hypothesis or its components however. We find relatively little evidence that East Asian countries are assigning increased weight to the yen in their exchange rate policies, despite a gradual increase in regional use of the yen as an invoicing currency. We also find that all of the increase in intra-regional trade in the 1980s can be attributed to rapid growth in East Asia; there is no evidence of an intensifying bias toward intra-regional trade as there is in Europe and the Western Hemisphere. Rather, East Asian countries are found to be strongly linked to North America. Finally, the effect of exchange rate stability on bilateral trade flows, though apparently significant statistically, may be due to reverse causality. Section 1: Introduction

Puzzles in International Financial Markets

Abstract: This paper presents a survey of two basic puzzles in international finance. The first puzzle is the `predictable excess return puzzle.' The returns on foreign currency deposits relative to domestic currency deposits should be equalized based upon uncovered interest parity. However, not only do researchers find that deviations from uncovered interest parity are predictable ex ante, but their variance exceeds the variance in expected exchange rate changes. In the paper, I describe different explanations of this phenomenon including the view that excess returns are driven by a foreign exchange risk premium, peso problems or learning, and market inefficiencies. While the research to date has been able to better define the `predictable excess return puzzle' and to suggest the most likely directions for future progress, no one explanation has provided a full answer to the puzzle. The second puzzle is the `home bias puzzle.' Empirical evidence shows that domestic residents do not diversify sufficiently into foreign stocks. This evidence is clear whether looking at models based on portfolio holdings or outcomes of consumption realizations across countries. In this paper, I examine several possible explanations including non-traded goods and market inefficiencies, although even after considering these possibilities, the puzzle remains.

Speculative Attacks on Pegged Exchange Rates: An Empirical Exploration with Special Reference to the European Monetary System

Abstract: This paper presents an empirical analysis of speculative attacks on pegged exchange rates in 22 countries between 1967 and 1992. We define speculative attacks or crises as large movements in exchange rates, interest rates, and international reserves. We develop stylized facts concerning the univariate behavior of a variety of macroeconomic variables, comparing crises with periods of tranquility. For ERM observations we cannot reject the null hypothesis that there are few significant differences in the behavior of key macroeconomic variables between crises and noncrisis periods. This null can be decisively rejected for non-ERM observations, however. Precisely the opposite pattern is evident in the behavior of actual realignments and changes in exchange rate regimes. We attempt to tie these findings to the theoretical literature on balance of payments crises.

Cointegration, Fractional Cointegration, and Exchange Rate Dynamics

Abstract: Multivariate tests due to Johansen (1988, 1991) as implemented by Baillie and Bollerslev (1989a) and Diebold, Gardeazabal, and Yilmaz (1994) reveal mixed evidence on whether a group of exchange rates are cointegrated. Further analysis of the deviations from the cointegrating relationship suggests that it possesses long memory and may possibly be well described as a fractionally integrated process. Hence, the influence of shocks to the equilibrium exchange rates may only vanish at very long horizons. IN THE ARTICLE BY Baillie and Bollerslev (1989a), it is argued that seven different nominal spot and forward exchange rates all contain unit roots in their univariate time series representations. At the same time, however, the spot exchange rates appear to be tied together in the long run through a cointegration-type relationship. The latter finding of Baillie and Bollerslev has attracted particular interest and several studies such as those by Hakkio and Rush (1991) and Sephton and Larsen (1991) have already addressed this issue. Using the same data as the Baillie and Bollerslev article, Sephton and Larsen (1991) describe the evidence for the presence of cointegration as being "fragile" and note that mixed conclusions are reached by truncating the Baillie and Bollerslev sample at different points in time. Diebold, Gardeazabal, and Yilmaz (1994) henceforth Diebold et al., provide interesting evidence that application of the Johansen (1988, 1991) tests with and without an intercept will result in different inferences on the Baillie and Bollerslev data set. Furthermore, Diebold et al. carry out an ex ante forecasting experiment and find that the addition of an error correction term to the martingale model, as implied by the standard cointegration paradigm, fails to reduce the prediction mean square error when compared to a simple martingale model. This therefore leads Diebold et al. to conclude that "there exists substantial uncertainty regarding the existence of cointegration relationships among nominal dollar exchange rates." This article provides some additional evidence on the existence of such a long-run relationship among the same seven nominal spot exchange rates. After further analysis it appears that a form of cointegration does exist between the exchange rates, so that they do not drift apart in the long run. We argue that this form of cointegration is

Sources of Real Exchange Rate Fluctuations: How Important are Nominal Shocks?

Abstract: This paper attempts to identify the sources of real exchange rate fluctuations since the collapse of the Bretton Woods period. We use a structural VAR model with recursive long-run restrictions to decompose the real exchange rate series into three components, associated with supply, demand and monetary shocks. Our estimates imply that monetary shocks account for a substantial fraction of the variability of both yen and Deutschmark real exchange rate variations against the dollar. Demand shocks appear as the largest source of real exchange rate fluctuations for all the currencies considered, while supply shocks seem to play a minor role.

Foreign Direct Investment, Exchange Rate Variability and Demand Uncertainty

Abstract: Variable real exchange rates influence the country choice for location of production facilities by a multinational enterprise. With risk averse investors and fixed productive factors, a parent company should not be indifferent to the choice of production capacity location, even when the expected costs of production are identical across countries. If a non-negative correlation exists between real export demand shocks and real exchange rate shocks, the multinational will optimally locate some of its productive capacity abroad. The share of production capacity optimally located abroad increases as exchange rate volatility rises and as export demand shocks become more correlated. These theoretical results are confirmed by empirical analysis of quarterly United States bilateral foreign-direct- investment flows with Canada, Japan, and the United Kingdom.

Estimating Equilibrium Exchange Rates

Abstract: The problems of exchange rate misalignments and the resulting payments imbalances have plagued the world economy for decades. At the Louvre Accord of 1987 the Group of Five industrial countries adopted a system of reference ranges for exchange rate management, influenced by proposals of C. Fred Bergsten and John Williamson for a target zone system. The reference range approach has, however, been operated only intermittently and half-heartedly, and questions continue to be raised in policy and scholarly circles about the design and operation of a full-fledged target zone regime. This collection of essays by leading international economists explores one crucial issue in the design of a target zone system: the problem of calculating the fundamental equilibrium exchange rate (FEER). Williamson contributes an overview of the policy and analytic issues and a second essay on his own calculations. Other contributors discuss the conceptual and empirical issues involved in their own approaches to estimating equilibrium rates. Stanley Black provides a concluding appraisal of the state of the art.

Terms of Trade, Productivity, and the Real Exchange Rate

Abstract: The paper examines the effects of terms of trade movements and productivity differentials across sectors on the behavior of the real exchange rate. We develop a simple model of a small open economy producing exportable and nontradable goods and consuming importable and nontradable goods and present empirical evidence for a sample of fourteen OECD countries. The evidence broadly supports the predictions of the model, namely that faster productivity growth in the tradable relative to the nontradable sector and an improvement in the terms of trade induce a real appreciation.

A Survey of Empirical Research on Nominal Exchange Rates

Abstract: We survey the empirical literature on floating nominal exchange rates over the past decade. Exchange rates are difficult to forecast at short- to medium-term horizons. There is a bit of explanatory power to monetary models such as the Dornbusch 'overshooting' theory, in the form of reaction to 'news' and in forecasts at long-run horizons. Nevertheless, at short horizons, a driftless random walk characterizes exchange rates better than standard models based on observable macroeconomic fundamentals. Unexplained large shocks to floating rates must then, logically, be due either to innovations in unobservable fundamentals, or to non-fundamental factors such as speculative bubbles. The observed difference in exchange rate and macroeconomic volatility under different nominal exchange rate regimes makes us skeptical of the first view. The theory and evidence on speculative bubbles, however, is not conclusive. We conclude with the hope that promising new studies of the microstructure of the foreign exchange market might eventually rise to insights into these phenomena.

Trade barriers and trade flows across countries and industries

Abstract: We use disaggregated data on trade flows, production, and trade barriers for 41 countries in 1988 to examine the political and economic determinants of non-tariff barriers, as well as the impact of protection (both tariff and non-tariff) on trade flows. We use an econometric framework that allows for the simultaneous detennination of trade barriers and trade flows. Our results are consistent with political-economy theories of the determinants of protection: even after accounting for industry-specific factors, nations tend to protect industries that are weak, in decline, and threatened by import competition. Countries also give more protection to large industries; these might be thought of as politically important. Nations use tariffs, non-tariff barriers, and exchange rate controls as complementary instruments of protection.

Terms of Trade, Productivity, and the Real Exchange Rate

Abstract: The paper examines the effects of terms of trade movements and productivity differentials across sectors on the behavior of the real exchange rate. We develop a simple model of a small open economy producing exportable and nontradable goods and consuming importable and nontradable goods and present empirical evidence for a sample of fourteen OECD countries. The evidence broadly supports the predictions of the model, namely that faster productivity growth in the tradable relative to the nontradable sector and an improvement in the terms of trade induce a real appreciation.

On Cointegration and Exchange Rate Dynamics

Abstract: Baillie and Bollerslev (1989) have recently argued that nominal dollar spot exchange rates are cointegrated. Here we examine an immediate implication of their finding, namely, that cointegration implies an error-correction representation yielding forecasts superior to those from a martingale benchmark, in light of a large earlier literature highlighting the predictive superiority of the martingale. In an out-of-sample forecasting exercise, we find the martingale model to be superior. We then perform a battery of improved cointegration tests and find that the evidence for cointegration is much less strong than previously thought, a result consistent with the outcome of the forecasting exercise.

Workers remittances and the real exchange rate: a quantitative framework.

Abstract: Workers' remittances represent a sizeable component of international trade flows in goods and services. The paper tries to assess to what extent workers remittances are responsive to key macroeconomic variables. We first develop a simple model of altruistic transfers and show that the real exchange rate may play a crucial role in affecting the remittance behaviour of migrants. Econometric estimation of a remittance equation for a sample of five Mediterranean countries indicates that the real exchange rate is indeed a significant determinant of remittances. Further support in this respect comes from an analysis of remittance behaviour by foreign workers in Germany. We also find strong evidence to support the claim that remittances are altruistically motivated, as indicated by the systematically negative coefficient associated with recipients' income.

Currencies and Politics in the United States, Germany, and Japan

Abstract: International monetary coordination among the Group of Seven countries periodically falls into disrepair, due partly to the processes and institutions by which each government determines exchange rate and monetary policy. This study outlines the differences in how international monetary policy is made in the United States, Germany, and Japan, and examines how those differences complicate international policy coordination.

Exchange Rate Dynamics Redux

Abstract: Until now, thinking on open economy macroeconomics has been largely schizophrenic. When it comes to analyzing exchange rate dynamics, an empirically-minded economist abandons modern current account models which, while theoretically coherent, fail to address the awkward reality of sticky nominal prices. In this paper we develop an analytically tractable two-country model that marries a full account of dynamics to a supply framework based on monopolistic competition and sticky prices. It offers simple and intuitive predictions about exchange rates and current accounts that sometimes differ sharply from those of either modern flexible-price intertemporal models, or traditional sticky-price Keynesian models. The model also leads to a novel perspective on the international welfare spillovers of monetary and fiscal policies.