International real interest rate parity with error correction models

(ProQuest: ... denotes formulae omitted.)1. IntroductionExchange rates, which is simply the price of one currency in terms of another currency, are one of the key component of the macroeconomics discussions in the literature. If one want to understand why some currencies depreciate and others appreciate, the factors that cause the change in supply and demand of currencies must be investigated. These factors include various fundamentals such as real income, inflation rates, real interest rates, consumer preferences, and government trade policy. For example, Purchasing Power Parity (PPP) states that a country's currency will depreciate by an amount equal to the excess of domestic inflation over foreign inflation while Uncovered Interest Parity (UIP) suggests that the interest rate differentials change the exchange rates. Traditional Flow Approach, which is also called the balance-ofpayments view, states that exchange rate moves to keep the balance of payments in equilibrium under the assumption of no government interventions. On the other hand, nominal exchange rate fluctuations should reflect movements in a country's monetary fundamentals such as relative money, output, interest rates and prices, according to the Monetary Model of Exchange Rate Determination.One of the important debates centers on the international economics is the difficulty of predicting exchange rates by using monetary fundamentals such as money supplies, outputs, and interest rates. As stated above, some theories in the economic literature claim that the exchange rates might be determined by such fundamental variables. However, since Meese and Rogoff (1983), it has been considered that exchange rates are very difficult to predict using monetary fundamentals; in particular, a simple random walk without drift (RW), is found to produce better exchange rate forecasts than fundamental-based exchange rate models. In other words, fundamental variables do not help predict future changes in exchange ratesMeese and Rogoff's (1983) finding was a shock for economists since monetary fundamentals have long been considered key determinants of exchange rates. If their finding is true, then all exchange rate models based on the fundamentals are misleading. Therefore, large numbers of studies have attempted to refute Meese and Rogoff's findings and find positive results in favor of fundamentals-based models. One of the most well-known rebuttals to Meese and Rogoff's work is Mark's (1995) study. Mark concludes in his study that monetary fundamentals contain predictive power for exchange rate. He used the long horizon regression (or Error Correction Model (ECM)) derived from the VECM (Vector Error Correction Model). However, these two studies are not the only ones testing the predictive ability of exchange rate models. Several models such as the single equation linear models, single-equation ECM, multi-equation VECM models, time-varying parameter models, and panel models have been used in the literature in the attempt to predict exchange rates. Even though most of the authors are unable to document short-run exchange rate predictability, some of them find evidence of long horizon predictability. Nevertheless, the literature has remained pessimistic about the link between exchange rates and fundamentals.The main purpose of the study is to investigate the exchange rate predictability in Turkey by using the monetary fundamentals in the ECM. This study first examines the in-sample fit of the ECM model, and then evaluates the out-of sample forecast performance of the ECM against benchmark RW model. The fundamental value of exchange rate used in this study is obtained from Frankel-Bilson Monetary Model. The error correction term is constructed under the assumptions of zero/nonzero interest rate differentials and country specific money demand elasticities to satisfy the cointegration assumption between fundamentals and exchange rates. The in-sample analysis results present evidence that monetary fundamentals are useful to explain the long horizon changes in the logarithm of the exchange rates while the out-of sample analysis results suggest that whether the ECM or the RW explains the nature of exchange rate changes might be considered that time varying. …

The Yen/Dollar Carry Trade: Carrying the UIP Condition Too Far?

This study tests the joint effects of Government Investment, Gross Domestic Product (GDP), Real Interest Rates, and Government's Policy on realization of private investment in Indonesia from 1972 until 2005. Government investment, the level of GDP and real interest rate directly have causality relationship with private investment, meaning every change in government investment, the level of GDP and real interest rate will cause positive change to private investment. On the other hand, the level of real interest rate does not have significant effect on investment, meaning the level of interest rate is not the only main cause, there are some other factors such as: inefficient institution condition which can be seen from complexity of rules, legal compliance system, and political stability.

Previous articleNext article FreeDiscussionPDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinked InRedditEmailQR Code SectionsMoreThe authors started by thanking both discussants. They agreed with Robert Hall’s assessment that the paper contains two distinct parts but slightly disagreed on their characterization. They viewed the first part as proposing a mechanism for the propagation of a financial crisis and its effect on interest rates. The second part proposes a mechanism for the endogenous persistence of financial crises. The authors clarified that their paper focuses on persistence, whereas both discussants mostly focused on propagation. The authors argued that they opted for a simple yet quantitatively realistic propagation mechanism based on liquidity constraints. Their emphasis is on a novel persistence mechanism and its ability to explain a decrease in riskless interest rates over an extended period of time. Their persistence mechanism relies solely on agents not knowing the true distribution of shocks and estimating it over time.Gregory Mankiw spoke next and asked the authors why they focused specifically on the recent financial crisis instead of taking a more general approach. He suggested that they could study other related episodes, including the Great Depression and the Great Moderation. Several participants proposed alternative approaches to validate the authors’ mechanism. Gita Gopinath suggested looking at disasters in emerging markets. Valerie Ramey recommended investigating the response of land prices to earthquakes. Emmanuel Farhi proposed studying a broader class of assets and analyzing whether their behavior is consistent with the prediction of the authors’ theory. He suggested looking into the cross-section of stocks and exchange rates during and following the Great Recession. The authors were sympathetic to these suggestions. They explained that they could not extend their analysis to the Great Depression due to data limitations.Mankiw pointed out that real rates have decreased over time since the Great Depression, whereas the authors’ persistence mechanism would predict a recovery following the initial decrease. The authors confirmed that their mechanism would indeed predict such a recovery but noted that real rates are affected by other factors outside the scope of their analysis. Robert Gordon followed up on the issue and questioned the existence of a secular decline in real interest rates. He argued that inspecting the series for real rates from the 1980s onward is misleading, referring to a plot displayed by Hall during his discussion. Gordon noted that the 1980s were times of tight monetary policy and easy fiscal policy, which led to high real interest rates. He added that real interest rates were actually low in the 1960s due to surprise inflation during the Vietnam War and in the 1970s due to an oil supply shock. Gordon suggested that notion of a secular decline in real interest rates may become obsolete over the next 5 years.Andrea Eisfeldt followed up on the question of rare disasters and referred to the work of Tyler Muir (“Financial Crises and Risk Premia,” Quarterly Journal of Economics 132, no. 2 [2017]: 765–809). Using a large cross-section of countries and a long time series, Muir documents that bond spreads respond to bank net worth shocks but not to wars or other events affecting consumption growth or the capital stock. Eisfeldt noted that this finding suggests that the response of bond spreads to leverage shocks may be muted. On the other hand, she raised the possibility that shocks to the collateral value of banks could have a sizable effect. The authors were very receptive to Eisfeldt’s suggestion. They added that the response of spreads to an increase in perceived tail risk is quite modest in their model. The reason for this small response is that firms deleverage when credit risk increases. Eisfeldt noted that a friction to deleveraging would be required to obtain a larger effect.The rest of the discussion focused on the nature of belief formation in the authors’ model. Michael Woodford was very sympathetic to the idea that observing unusual events affects agents’ beliefs about the probability of tail risk. He viewed the authors’ evidence on options prices as compelling in this respect. Woodford was more skeptical, though, that the authors’ simple model of learning could capture important features of the belief formation process. He emphasized that the size of the data set that agents use to form their expectations plays a critical role. Woodford noted that if this data set expands over time, agents will infer the true distribution of shocks asymptotically, so surprises about this distribution eventually disappear. He concluded that the window must be of finite length for the authors’ mechanisms to be present in the long run. In Woodford’s opinion, a window of fixed length wouldn’t be particularly relevant either. As an example, he noted that prior to the Great Recession many economists assumed data prior to World War II was no longer relevant for assessing risks for the US economy, invoking policy and institutional changes. After the Great Recession, however, there was a renewed interest in the profession in the Great Depression and its policy lessons. Woodford argued that it is important to endogenize the window used for belief formation.Pierre-Olivier Weill seconded Woodford’s point and suggested that the natural next step would be a model of attention choice, where agents choose which episodes to consider when forming their beliefs. Wendy Edelberg noted that agents’ beliefs may overshoot in response to a tail event. This response is not captured in the authors’ model. She raised the possibility that this mechanism could decrease the degree of persistence in their model, as agents realize that their beliefs are incorrect. Martin Eichenbaum added that there is strong evidence of generational effects: old households put a lower weight on new observations when forming beliefs, relative to young households. Eichenbaum provided two examples: heterogeneity in inflation expectations by age and in risk taking in the financial industry between those who experienced the 2007–8 crisis and those who did not.In response to Woodford, the authors said they saw a virtue in considering a modest deviation from rational expectation and showing that it yields a substantially different response to rare events. They added that they also performed an exercise in which they discounted the weights on observations by 1% a year, which may capture the generational effect mentioned by Eichenbaum.Eichenbaum concluded the general discussion by inviting researchers to be less apologetic about deviating from rational expectations. Previous articleNext article DetailsFiguresReferencesCited by NBER Macroeconomics Annual Volume 332018 Sponsored by the National Bureau of Economic Research (NBER) Article DOIhttps://doi.org/10.1086/700913 © 2019 by the National Bureau of Economic Research. 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Analysis of Relations in Uncovered Interest Rate Parity: Example of CZK/EUR Exchange Rate The aim of the paper is to make an empirical verification of both concepts of the validity of uncovered interest rate parity, ex post and ex ante, using the predicted CZK/EUR exchange rate (for one month and one year) as a proxy variable for market expectations. We formulate the difference between the econometric procedures applied in the case of stationary and non-stationary time series. We perform a cointegration analysis and empirical verification of the error correction model, where PRIBOR interest rates and the actual and expected development of the CZK/EUR spot rate act as endogenous variables. The foreign EURIBOR interest rate (one-month and one-year) is considered an exogenous variable in our analysis, as we do not assume the influence of the Czech economy on this interest rate. We have found that long-term cointegration relations within the uncovered interest rate parity are determined by the inflation-targeting policy pursued by the CNB since 1998. In short-term relations, the foreign EURIBOR interest rate determines the development of the domestic PRIBOR interest rate. The development of the CZK/EUR spot exchange rate is sensitive to changes in the VIX global financial risk indicator. Growth of the VIX indicator leads to a weakening of the Czech koruna on the one-month time horizon and to its retrospective strengthening over the one-year time horizon. Changes in the expected CZK/EUR spot exchange rate respond in a corrective way to previous changes in expectations, in the case of both month- ly and annual forecast horizons. The depreciation (appreciation) of the CZK/EUR spot ex-change rate is associated with the subsequent expected depreciation (appreciation) of the ko- runa exchange rate. This fact signals the adaptability of exchange rate expectations over the monthly and annual forecast horizons.

Understanding the behavior of real interest rates is a central issue in monetary/macro economics. Recently researchers have begun to use futures market data to examine real interest rate behavior. Futures market data can be used to directly construct own-commodity real interest rates ? i.e., the ex-ante real return on a bond in terms of specific commodities -- and then the own-commodity real rates can be used to make inferences about the real interest rate for the aggregate economy, This paper examines whether futures market data can be used to understand the behavior of real interest rates. The conclusion is a negative one: Futures market data do not appear to be particularly informative about real interest rates. In coming to this conclusion, the paper examines the data in several ways. First. the ex-ante relative price movement embedded in the own-commodity real rates (the noise) is calculated to be on the order of over one hundred times more variable than the aggregate real interest rate (the signal), Own-commodity real rates are thus unlikely to contain much information about the aggregate real interest rate. Second. several widely accepted facts about the behavior of aggregate real interest rates in the 1960s are not at all evident in the own-commodity real rate data. Thus, analysis of own- commodity real rates provides a misleading impression of aggregate real rate movements for a period which displays the most striking movements of real interest rates in the postwar period. Finally, an econometric analysis of own-commodity real rate behavior fails to find evidence of a shift in the behavior of real interest rates when the monetary policy regime changes in October 1579, a finding that is at odds with previous strong findings in the literature.

The real rate of interest from 1800–1990: A study of the U.S. and the U.K.

How real interest rates behave over time is critical to our understanding of many macroeconomic issues, and much recent research has pursued this question. Very little of the research, however, has focused on real interest rates outside the United States. This paper is an empirical exploration of real interest rate movements in seven OECD countries from 1967-II to 1979-II. Further research is needed on real rates in other countries for several reasons. Not only are measures of foreign real rates of interest in their ownright, but extending an analysis of real rates to other countries also has the following additional benefits: it can generate more powerful statistical tests of propositions previously tested on U.S. data and yield information on whether results found for the U.S. hold up in other countries.This study pursues several questions that have arisen naturally from this earlier work. Is the hypothesis that the real rate is constant rejected when the analysis is extended to other countries? Does the real rate decline with increased inflation and money growth in other countries besides the United States? How reliable is the Fisher effect, in which nominal interestrates reflect changes in expected inflation? Are movements in nominal interest rates a reliable indicator of movements in real rates? What kind of variationsin real interest rates are there in different countries? Have real rates declined from the '60s to the '70s for other countries besides the U.S.?(This abstract was borrowed from another version of this item.)

Interest Rate Sensitivity of Savings: The Ghanaian Experience

References and Further Reading

Two Essays on General Equilibrium Foundation of Finance

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Real interest rate equalization and the integration of international financial markets

This paper empirically explores how fiscal policy (represented by increases in government spending) has asymmetric effects on economic activity at different levels of real interest rates. It suggests that the effect of fiscal policy depends on the level of real rates, since the Ricardian effect is smaller at lower financing costs of fiscal policy. Using threshold regression models on U.S. data, the paper provides new evidence that expansionary government spending is more conducive to short-run growth when real rates are low. It also finds asymmetric effects on interest rates and inflation, and threshold effects associated with substitution between financing methods.