Mt AtMti and Nt A

Where (At, A) are exogenous random gross rates of change in M and N. If the domestic household received transfers only of M, it faces foreign purchasing-power risk because it it also needs N to buy y-goods. Introducing the second currency creates a new country-specific risk that households will want to hedge. The complete markets paradigm allows markets to develop whenever there is a demand for a product. The products that individuals desire are claims to future dollar and euro transfers.5 So...

Long Run Analyses of Real Exchange Rates

Empirical research into the long-run behavior of real exchange rates has employed econometric analyses of nonstationary time series and is aimed at testing the hypothesis that the real exchange rate has a unit root. This research can potentially provide evidence to distinguish between the Casselian and the Balassa-Samuelson views of the world. Univariate Tests of PPP Over the Float To test whether PPP holds in the long run, you can use the augmented Dickey-Fuller test (chapter 2.4) to test the...

T FoVt tj FoVtj Cj etj Cj FoVtj FjVtj

13They are only identifying restrictions, however, and cannot be tested. 14Cointegration is discussed in Chapter2.6. Fj CjFo for all j F(1) C(1)Fo. (8.47) Given the Cj, which you get from unrestricted VAR accounting, (8.47) says you only need to determine Fo after which the remaining Fj follow. In our 3-dimensional system, Fo is a 3 X 3 matrix with 9 unique elements. To identify Fo, you need 9 pieces of information. Start with, E G'G E(etet) FoE(vtvt)Fo FoFo where G is the unique upper...

First Generation Model

In first-generation models, the government exogeneously pursues fiscal and monetary policies that are inconsistent with the long-run maintenance of a fixed exchange rate. One way to motivate government behavior of this sort is to argue that the government faces short-term domestic financing constraints that it feels are more important to satisfy than long-run maintenance of external balance. While this is not a completely satisfactory way to model the actions of the authorities, it allows us to...

Fama Decomposition Regressions

Although the preceding Monte Carlo experiment suggested that you can achieve efficiency gains by using overlapping observations, in the interests of simplicity, we will go back to working with the log one-period forward rate, t t 1 to avoid inducing the moving average errors. Define the expected excess nominal forward foreign exchange payoff to be where Et st 1 E st 1 t . You already know from the Hansen-Hodrick regressions that pt is non zero and that it evolves overtime as a random process....

Cassels Approach

The intellectual origins of PPP began in the early 1800s with the writings of Wheatly and Ricardo. These ideas were subsequently revived by Cassel 22 . The Casselian approach begins with the observation that the exchange rate S is the relative price of two currencies. Since the purchasing power of the home currency is 1 P and the purchasing power of the foreign currency is 1 P , in equilibrium, the relative value of the two currencies should reflect their relative purchasing powers, S P P ....

The Maddala and Wu Test

Maddala and Wu 99 point out that the IPS strategy of combining independent tests to construct a joint test is an idea suggested by R.A. Fisher 53 . Maddala and Wu follow Fisher's suggestion and propose following test. Let the p-value of Ti from the augmented Dickey-Fuller test for a unit root be pi Prob T lt Ti f x dx be the p-value of Ti from the ADF test on 2.72 , where f t is the probability Table 2.5 Selected Exact Critical Values for the IPS Tnt Statistic Table 2.5 Selected Exact Critical...