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Equilibrium ER

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.

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Equilibrium ER

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  1. 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

  2. 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

  3. Empirical evidence : B-S effect

  4. 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

  5. Example of other theories • Monetary model of ER:

  6. 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?

  7. Slovak price level low

  8. Slovak FDI inflows

  9. 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

  10. 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

  11. REER indices

  12. RER (de-trended)

  13. In-sample approach – estimates are likely biased

  14. 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

  15. 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

  16. 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?) -

  17. In-sample approach - results

  18. 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

  19. 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)

  20. 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

  21. Cointegration tests • We used following residual based cointegration tests: • Kao (1997) • Kao (1999) • Pedroni (1995) • Pedroni (1999) (15 tests together)

  22. Results

  23. ER misalignments

  24. An out-of Sample Experiment

  25. 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

  26. FT equations Exports Imports

  27. External gap at potential level

  28. FEER

  29. Improvement – panel evidence

  30. Equilibrium estimates (FEER)

  31. 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.

  32. 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

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