Conventions in the Foreign Exchange Market: Do they really Explain Exchange Rate Dynamics ?

1. Third FIW Research Conference in International Economics Conventions in the Foreign Exchange Market:Do they really Explain Exchange Rate Dynamics ? Gabriele Di Filippo LEDA-SDFi University Paris IX Dauphine

2. 1 Intuition Stylised Fact: De Grauwe (2000) [Statistical Study] « Market agents look for fundamentals that justify the dynamics of exchange rates » Examples: Appreciation of the dollar vis-à-vis the euro between January 1999 and December 2002 → High growth perspectives in the US economy Depreciation of the dollar vis-à-vis the euro between January 2003 and December 2004 → Fears concerning the sustainability of the US debt Bachetta and Van Wincoop (2005) [Theoretical Study] Theoretical model based on the idea of De Grauwe (2000) – « Scapegoat Model »

3. 2 The Main Pillars of Convention Theory Definition: Financial Convention (Orléan (2002)) = « Particular model based on fundamentals and adopted by the majority of agents in the market » The Building of Conventions: Step 1: Research of the Convention => Existence of multiple equilibria => High exchange rate volatility Step 2: Adoption of the Convention => Adoption of a specific fundamental model => Low exchange rate volatility Step 3: End of the Convention => Empirical facts against the convention => High exchange rate volatility

4. 3 Identification of the Prevailing Conventions on the Euro/Dollar Exchange Rate July 2003 - December 2005: : “the US as a net debtor” vs “the US as the engine of the world economy” July 2007 - December2008: subprime crisis January2006 – June 2007: “the US as a net debtor” January 2001 - June 2003 : end internet convention January 1995 - December 2000 : internet convention Figure 1 : Dynamics of the Euro/Dollar exchange rate between January 1995 and December 2008 Growth Rate Debt Oil Prices; House Prices; Debt Growth Rate; Debt

5. 4 Empirical Model Endogeneous Variables: Euro/Dollar Nominal Exchange Rate (1 euro = S dollars) Exogenous Variables:Bull State: Growth Rate of the Industrial Production Growth Rate of Expected Profits Bear State: External Debt/ GDP Oil Prices US House Prices Estimation Period: January 1995-December 2008 Data Frequency: Daily Estimation Method:EM algorithm (Hamilton (1990))

6. 5 Results Estimated Model (Recall): Table 1: Estimation output → Bull Market : Increase in Growth Rate => Appreciation of the dollar Surprising result on Expected Profits (multicollinearity?) → Bear Market: Increase in Debt => Depreciation of the dollar Increase in Oil Prices => Depreciation of the dollar Increase in US House Prices => Depreciation of the dollar

7. 6 Does the Model represent the Variations of Conventions ? Econometrical Result (Filtered Probabilities) Conventions Analysis

8. 6 Does the Model represent the Variations of Conventions? January 2006 – June 2007 July 2007 - December 2008 January 1995 - December 2000 January 2001 – June 2003 July 2003 - December 2005 Figure 2 : Filtered Probabilities and Euro/Dollar Dynamics (January 1995 - December 2008) Internet Convention; Bull Market; Appreciation of the dollar End internet convention; Bear Market Depreciation of the dollar Two opposed conventions ; Bull/Bear; Appreciation/Depreciation of the dollar Domination of the bear convention; Depreciation of the dollar

9. 7 Exchange Rate Volatility and Conventions Variations Excess of Exchange Rate Volaility Econometrical Result (Filtered Probabilities)

10. 7 Exchange Rate Volatility and Conventions Variations Figure 3 : Filtered Probabilities and Euro/Dollar Excess Volatility => Episodes of high exchange rate volatility coincide with conventions variations: research for a new convention (step 1) or end of a new convention (step 2) => Exchange rate volatility comes from the uncertainty concerning the prevailing convention in the market => When the future becomes uncertain, Public Authorities should intervene in the market to guide agents

11. 8 Resolution of the Exchange Rate Disconnection Puzzle Exchange Rate Disconnection Puzzle (Meese et Rogoff (1983)): => Exchange Rate Dynamics is disconnected from the fundamentals Advantages related to the Convention Model: => Asymmetric World => Non-Linear Structure Problems with Traditional Models of Exchange Rate: Invariance of the coefficients associated to fundamentals => Exchange Rate Disconnection Puzzle = Pure Artefact ?

12. 9 Limits of the Model Limits: Daily Frequency Model => Extrapolation of Macroeconomic Data => Very Strong Hypothesis => Highly contestable hypothesis Choice of the Variables ? Questions: Is the model correctly specified ? If the model is badly specified, then why does it provide the expected results ?

13. 10 Other Filtered Probabilities in monthly variation with daily data:

14. 11 Other Filtered Probabilities in monthly variation with monthly data: