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Equilibrium ER

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# Equilibrium ER - PowerPoint PPT Presentation

Equilibrium ER. PPP: Empirical evidence: Define: Test the behavior of RER If RER is non-stationary -&gt; PPP does not hold If RER is stationary -&gt; PPP might hold Conclusion (Rogoff (1986)): RER is mean reverting albeit very slowly with half statistics of mean reversion around 4 years.

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Equilibrium ER
• PPP:
• Empirical evidence:
• Define:
• Test the behavior of RER
• If RER is non-stationary -> PPP does not hold
• If RER is stationary -> PPP might hold
• Conclusion (Rogoff (1986)): RER is mean reverting albeit very slowly with half statistics of mean reversion around 4 years.

This is too long time period to be explained by reasonable nominal rigidities or barriers to arbitrage.

Rogoff, K. (1996),”The Purchasing Power Parity Puzzle”, Journal of Economic Literature, vol. 34, June 1996, pp.:647-668

Fact: RER is highly persistent
• Implications:
• Problems with econometric inference
• We need to explain these large swings in RER
• Unfortunately, many theories are lacking micro-foundations
• Possibly the best explanations – Balassa-Samuelson efect:
• Poorer countries have cheaper price level
• Improvement in productivity in tradable sector (relative to foreign country) appreciate ER.
• Improvement in productivity in non-tradable sector (relative to foreign country) depreciate ER

Balassa, B. (1964),”The Purchasing Power Parity Doctrine: A Reappraisal”, Journal of Political Economy, vol. 72, December, pp. 584-596

Samuelson, P. (1964),”Theoretical Notes on Trade Problems”, Review of Economics and Statistics, vol. 23, pp.: 1-60

Harrod, R. F. (1933), International Economics, London: James Nisbet and Cambridge University Press

B-S is not enough
• MacDonald and Ricci (2001): Enlarged standard B-S framework by distribution sector.
• MacDonald and Ricci (2002): Tested implication of new trade theory on ER. (They focus on imperfect substituability of tradables and on the importance of competitiveness)
• others
• There is no theory (with proper micro-foundations) satisfactory explaining behavior of RER

MacDonald, R. and Ricci, L. (2001),”PPP and the Balassa Samuelson Effect: The Role of the Distribution Sector”, IMF Working Paper, WP/01/38

MacDonald, R. and Ricci, L. (2002),”Purchasing Power Parity and New Trade Theory”, IMF Working Paper, WP/02/32

Example of other theories
• Monetary model of ER:
Let PPP condition hold only in the long-run, and assume prices are sticky in the short-run -> Dornbusch overshooting model.
• Able to explain excessive volatility of ER
• But: Why are prices sticky?
Empirical development
• Various approaches
• Most common: BEER and FEER
• Persistent behavior of RER -> problems with econometric estimates
• Assumption of non-stationarity cannot be satisfactory rejected due to ‘short sample’
• In all BEER estimations, RER is assumed to be I(1) – i.e. simple PPP does not hold
BEER
• Most common
• Tries to find direct behavioral link between RER and fundamentals (assumes variables to be I(1)).
• Absolutely no micro foundation
• Fundamentals: everything one suspect might affect RER
Unit root tests
• Single time serries
• We performed: ADF , KPSS Kwiatkowski-Phillips-Schmidt-Shin (1992) , Ng-Perron Ng-Perron (2001)
• Conclusion: All series are I(1)

Kwiatkowski, D., Phillips, P. C. B., Schmidt, P. and Shin, Y. (1992),”Testing the Null Hypothesis of Stationary against the Alternative of a Unit Root”, Journal of Econometrics, vol. 54, pp.: 159-178

Ng, S. and Perron, P. (2001),”Lag Length Selection and the Construction of Unit Root Tests with Good Size and Power”, Econometrica, vol. 69, pp.: 1519-1554

Fundamentals
• We chose:
• Proxy for Ballassa-Samuelson effect (e.g. relative price of non-tradables vs tradables (NT) or relative labour productivity in tradables vs nontradables (LP))
• (ToT) Terms of trade (i.e. export prices relative to import prices) intend to capture changes in international economic environment.
• (gov) Share of government spending on GDP - intends to capture the effects of fiscal policy.
• (rr) Real interest rate differential. Higher interest rate differential should attract more capital inflows.
• Proxy for country risk. We used following proxies: country rating (rat), spreads on Eurobonds (spread), our currency vulnerability index adjusted for movements in RER (vul); NFA

Able to estimate country specific behavior

+

Single country approach

Short sample (about a decade) , RER is highly persistent

Estimates are not robust

RER is likely to be undervalued for longer period in the first phase of transition

-

Estimates are biased

Plenty of ad hoc-factors affecting early stage of transition

Questionable quality of data on the early stage of transition

Possibility of structural breaks

Measurement error

Cross section approach

Missing time series dimension

-

(Impossible to account for country specific effects)

Partially helps to solve problems connected with short sample

Aims to estimate ‘specific’ behavior of countries in transition

Estimation of BEER

+

In-sample estimates

Including only

accession countries

Estimates are still biased

-

Heterogeneity ?

Using data from early stage is still questionable

+

Helps to solve problems connected with short sample

Panel data approach

Including broader

set of countries

Biased L-R estimates

-

Biased constant term

Estimates are not biased finally

+

Heterogeneity ?

Out-of-sample estimates

No constant for accession country (country-specific effect)

Heterogeneity ? (is homogenous long run behavioral assumption for each country plausible?)

-

Improvement – panel considerations
• How to estimate?
• Assumptions:
• Homogeneous L-R behavior
• Heterogeneous (country specific) short-run behavior
• Data are likely I(1)
• Other country specific conditions affecting L-R:
• Fixed effects
Panel Unit root tests
• We performed:
• Levin, Lin and Chu t, Levin, Lin and Chu (2002); Breitung t-stat, Breitung (2000)
• Im, Pesaran and Shin W-stat, Im, Pesaran and Shin (2003); ADF - Fisher Chi-square, PP - Fisher Chi-square, Maddala and Wu (1999) and Choi(2001)
• Hadri Z-stat, Hadri (2000)

Conclusion: All variables are I(1) rather than I(2) or I(0)

References

Levin, A., Lin, C. F., and Chu, C. (2002),”Unit Root Tests in Panel Data: Asymptotic and Finite-Sample Properties,” Journal of Econometrics, Vol. 108, pp.:1-24

Breitung, J. (2000),”The Local Power of Some Unit Root Tests for Panel Data,” in Baltagi (ed.), Advances in Econometrics, Vol. 15: Nonstationary Panels, Panel Cointegration, and Dynamic Panels, Amsterdam: JAI Press, pp.:161-178

Im, K. S., Pesaran, M. H., and Shin, Y. (2003),”Testing for Unit Roots in Heterogeneous Panels”, Journal of Econometrics, Vol. 115, pp.: 53-74

Maddala, G. S., and Wu, S. (1999),”A Comparative Study of Unit Root Tests with Panel Data and A New Simple Test, Oxford Bulletin of Economics and Statistics, Vol. 61, pp.:631-652

Choi, I. (2001),”Unit Root Tests for Panel Data,” Journal of International Money and Finance, Vol. 20, pp.:249-272

Hadri, K. (2000).”Testing for Stationarity in Heterogeneous Panel Data,” Econometrics Journal, Vol. 3, pp.:148-161

Cointegration tests
• We used following residual based cointegration tests:
• Kao (1997)
• Kao (1999)
• Pedroni (1995)
• Pedroni (1999)

(15 tests together)

Alternative approach: FEER
• Flow approach: FEER = value of RER consistent with medium achievement of sustainable C/A balance
• Use of econometric models
• Most important: FT equations
FT equations

Exports Imports

Conclusion
• Koruna will definitely be appreciating in real terms, at least for the next two decades. This is connected with fact that the country is economically just at 40% of EU average and this huge gap will continue to be diminishing slowly in the future.
• It is tricky to estimate the precise speed of sustainable appreciation. Data problems, short sample, and structural changes are the obvious challenges. First results point to more than 1.7% real appreciation in the years ahead. Then the pace of appreciation is likely to slow down to about 0.5-1.5% in the medium- to longer-term.
As for the current equilibrium level of Koruna, it is even more tricky to estimate it. According to the preliminary research, koruna is slightly undervalued at present – equilibrium being about Sk39.3/Eur (June). Our estimates comfortably support Sk39/€ in 4Q04 to be fully in line with macro picture or even slightly over-valuated. Furthermore, based on the preliminary (!) data, Koruna could be entering ERMII in 2006 at Sk36-37/€.
• Worries of CB about too strong ER at the moment might not be justified