The Romanian Real Exchange Rate: Estimation of Responses to Real and Monetary Shocks

1. ACADEMY OF ECONOMIC STUDIES DOFIN 2009 The Romanian Real Exchange Rate: Estimation of Responses to Real and Monetary Shocks Coord. Prof. Moisa Altar, Ph.D stud. Ana-Maria CastraveteBalaita

2. Introduction The importance of studying the types of shocks that affect the real exchange rate is twofold: • Regarding monetary and governmental policies; e.g. justifying or not a controlled nominal exchange rate; • Regarding the economic theoretical models that include this variable; e.g. invalidation of the PPP or of the uncovered interest parity hypothesis;

3. Overview of economic literature • Identifying permanent and temporary shocks of the real exchange rate has followed two main directions suring the last two decades: • Identifying one permanent and one temporary shock, with the approximation that the former includes real shocks and the latter monetary shocks. Lastrapes (1992), Evans&Lothian (1993), Enders&Lee (1997), Dibooglu and Kutan (2001), Narayan (2008) analyze the shocks on the real rate of the USD with the main trading partners, including in the Blanchard Quah decomposition the time series of nominal exchange rate or inflation in the home and foreign countries;

4. Overview of economic literature(cont.) • 2. Identifying different types of monetary and real shocks that influence the real exchange rate by including in the analysis variables such as government consumption, GDP, monetary aggregates, prices: Clarida &Gali (1994), Rogers (1999), Alexius (2005); • Unlike the previous approach, this allows the identification of various type of real and monetary shocks, which are possibly acting in opposite ways.

5. Overview of economic literature(cont.) • The theoretical models used in the literature follow two main models: • The Dornbusch “overshooting” model (1976), according to which the fluctuations of the real exchange rate in the short run are due to monetary shocks; • The Stockman model (1980), according to which the fluctuations in the real exchage rate are caused by real shocks both on the short and long-time horizon.

6. Identification of the model: types of shocks and variables • The shocks on the real exchange rate are: • Fiscal shocks – increases of government taxes. Influences the variable “Share of government consumption in GDP”; • Productivity shocks. Influences the “RealGDP” variable; • Preference shocks – changes in preferences of the population towards or away traded goods. Influences the variable “Real exchange rate “; • Monetary shocks. Influences the variable “Consumer Price Index “.

7. Solving the model: restrictions The long-run restrictions are as follows: • The productivity, preference and monetary shocks do not affect the share of government consumption in GDP; • The preference and monetary shocks do not affect real GDP; • The monetary shock does not affect the real variables (share of government consumption, real GDP and consumer preferences)

8. Solving the model: data • Save for the real RON/EUR exchange rate, the series are calculated as log differential between the value of the variable in Romania and the value in the Euro zone (Source: Eurostat). • Frequency: quarterly, over 1998:3 – 2000:3 • The differential of government consumption share of GDP; • The real GDP differential; • Log of real exchange rate; • CPI differential, base July 2000. • Real GDP series and the series of government consumption share of GDP are deseasonalized (using Tramo/Seats);

9. Unit root tests

10. VAR estimation • Stationarity condition:

11. VAR estimation • Normality of the residuals:

12. VAR estimation • White's test:

13. Long-run restrictions • The restrictions are imposed according to the equation: • Yt =

14. Impulse Response Functions of the real exchange rate

15. The response of the change in the real exchange rate to shocks • The relative fiscal shock generates an initial appreciation of the real exchange rate, indicating that an increase of taxation encourages consumption of non-tradable goods; • The productivity shock generates an appreciation of the real exchange rate which is persistent in the log-run.

16. The response of the change in the real exchange rate to shocks (cont.) • As expected, the preferences shock generates a depreciation of the real exchange rate that remains permanent above the level of the initial shock. We notice that the supply shock (previous table) and the demand shock (current table) have contrasting influences over the real exchange rate, thus justifying our approach of using several “real” variables in order to identify various real structural shocks. • The monetary shock generates an initial appreciation of the real exchange rate, indicating price stickiness, which is absorbed within approximately a year.

17. Variance decomposition

18. Variance decomposition (cont.) • The largest part of the forecast error variance is due to the productivity shock, followed by the preference and the fiscal shock; • The monetary shock has an extremely small influence; • The majority of studies of structural shocks affecting the real exchange rate find over 50% of the forecast error variance explained by real (or “permanent”) shocks, although the percentage due to monetary shocks is much larger.

19. Historical decomposition – fiscal shock

20. Historical decomposition – productivity shock

21. Historical decomposition – preference shock

22. Historical decomposition – monetary shock

23. Historical decomposition (cont.) • the fiscal and preference shocks act in opposite directions in influencing the RER; during the two main swings of the real path: the preference shock influences towards the depreciation of the RER and the fiscal shock towards appreciation.

24. Conclusions • The shocks affecting the RON/EUR real exchange rate are over 95% real in nature; • The real shock with the most important weight is the productivity shock; the historical decomposition shows that the main changes in the RER are due to this shock; • The real shocks have contradictory signs, which justifies the inclusion of more than one "real" variable in our model;

25. Conclusions (cont.) • The results regarding the shocks that influence the EUR/RON real exchange rate are in line with the findings for the developed countries and also with the results obtained by Dibooglu&Kutan (2001) for Hungary; • These findings confirm the predictions of the "equilibrium" models over those of the "disequilibrium" models;

26. References • Alexius, A. (2005). Productivity shocks and real exchange rates. Journal of Monetary Economics, 52, 555−566. • Blanchard, O. J., & Quah, D. (1989). The dynamic effects of aggregate demand and supply disturbances. American Economic Review, 79, 655−673. • Clarida, R., & Gali, J. (1994). Sources of real exchange rate fluctuations: How important are nominal shocks? Carnegie Rochester Series on Public Policy, 41, 1−56. • Devereux, M. B., & Lane, P. R. (2003). Understanding bilateral exchange rate volatility. Journal of International Economics, 60, 109−132. • Dibooglu, S., & Kutan, A. M. (2001). Sources of real exchange rate fluctuations in transition economies: The case of Poland and Hungary. Journal of Comparative Economics, 29, 257−275. • Dornbush, R. (1976). The theory of flexible exchange rate regimes and macroeconomic policy. Scandinavian Journal of Economics, 78, 255−275.

27. Bibliografie • Enders, W., & Lee, B. -S. (1997). Accounting for real and nominal real exchange rate movements in the post-Bretton Woods period. Journal of International Money and Finance, 16, 233−254. • Evans, M. D. D., & Lothian, J. R. (1993). The response of exchange rates to permanent and transitory shocks under floating • Jang, K., & Ogaki, M. (2004). The effects of monetary policy shocks on exchange rates: A structural vector error correction model approach. Journal of Japanese and International Economies, 18, 99−114.

28. Bibliografie • Joyce, J. P., & Kamas, L. (2003). Real and nominal determinants of real exchange rates in Latin America: Short-run dynamics and long-run equilibrium. Journal of Development Studies, 39, 155−182. • Lastrapes, W. D. (1992). Sources of fluctuations in real and nominal exchange rates. Review of Economics and Statistics, 74, • 530−539. • Lee, J., & Chinn, M. D. (2006). Current account and real exchange rate dynamics in the G7 countries. Journal of International • Money and Finance, 25, 257−274. • Messe, R., & Rogoff, K. (1988).Was it real? The exchange rate interest differential relation over the modern floating rate period. • Journal of Finance, 43, 933−948. • Rogers, J. (1999). Monetary shocks and real exchange rates. Journal of International Economics, 49, 269−288. • Stockman, A. C. (1980). A theory of exchange rate determination. Journal of Political Economy, 88, 673−698. • Stockman, A. C. (1987). Equilibrium approach to exchange rates. Federal Reserve Bank Richmond Economic Review, 73, 12−30.