Revisiting the Dollar-Euro Permanent Equilibrium Exchange Rate: Evidence from Multivariate Unobserved Components Models

We propose an alterative approach to obtaining a permanent equilibrium exchange rate (PEER), based on an unobserved components (UC) model. This approach offers a number of advantages over the conventional cointegration-based PEER. Firstly, we do not rely on the prerequisite that cointegration has to be found between the real exchange rate and macroeconomic fundamentals to obtain non-spurious long-run relationships and the PEER. Secondly, the impact that the permanent and transitory components of the macroeconomic fundamentals have on the real exchange rate can be modelled separately in the UC model. This is important for variables, where the long and short-run effects may drive the real exchange rate in opposite directions, such as the relative government expenditure ratio.Permanent Equilibrium Exchange Rate; Unobserved Components Model; Exchange rate forecasting.

Realised and Optimal Monetary Policy Rules in an Estimated Markov-Switching DSGE Model of the United Kingdom

This paper conducts a systematic investigation of parameter instability in a small open economy DSGE model of the UK economy over the past thirty-five years. Using Bayesian analysis, we find a number of Markov-switching versions of the model provide a better fit for the UK data than a model with time-invariant parameters. The Markov-switching DSGE model that has two independent Markov-chains - one governing the shifts in UK monetary policy and nominal price rigidity and one governing the standard deviations of shocks - is selected as the best fitting model. The preferred model is then used to evaluate and design monetary policy. For the latter, we use the Markov-Jump-Linear-Quadratic (MJLQ) model, as it incorporates abrupt changes in structural parameters into derivations of the optimal and arbitrary policy rules. It also reveals the entire forecasting distribution of the targeted variables. To our knowledge, this is the first paper that attempts to evaluate and design UK monetary policy based on an estimated open economy Markov-switching DSGE model.DSGE models; Markov-switching; Bayesian analysis

Measuring the Euro area output gap using multivariate unobserved components models containing phase shifts

This paper analyses the impact of using different macroeconomic variables and output decompositions to estimate the euro area output gap. We estimate twelve multivariate unobserved components models with phase shifts being allowed between individual cyclical components. As output decomposition plays a central role in all multivariate models, three different output decompositions are utilised; these are a first-order stochastic cycle combined with either a local linear trend or a damped slope trend, and a second-order cycle plus an appropriate trend specification (a trend following a random walk with a constant drift is generally preferred). We also extend the commonly used trivariate models of output, inflation and unemployment to incorporate a fourth variable, either investment or industrial production. We find that the four-variate model incorporating industrial production produces the most satisfactory output gap estimates, especially when the output gap is modelled as a first-order cycle. In addition, measuring phase shifts and calculating contemporaneous correlations between individual cyclical components provides a better understanding of the different gap estimates. We conclude that the output gap estimate in all models leads the cyclical components of inflation and unemployment, but lags those of industrial production and investment. Furthermore, the output gap estimates obtained from the four-variate model including investment present the longest leads-and-lags with respect to other cyclical components, implying that investment appears to be more of a leading indicator than a coincident variable for the euro area.output gap, higher-order cycle, industrial production, state-space, Kalman filter.

Measuring the Euro-Dollar Permanent Equilibrium Exchange Rate using the Unobserved Components Model

This paper employs an unobserved component model that incorporates a set of economic fundamentals to obtain the Euro-Dollar permanent equilibrium exchange rates (PEER) for the period 1975Q1 to 2008Q4. The results show that for most of the sample period, the Euro-Dollar exchange rate closely followed the values implied by the PEER. The only significant deviations from the PEER occurred in the years immediately before and after the introduction of the single European currency. The forecasting exercise shows that incorporating economic fundamentals provides a better long-run exchange rate forecasting performance than a random walk process

An Empirical Assessment of Optimal Monetary Policy Delegation in the Euro Area

We estimate a New Keynesian DSGE model for the Euro area under alternative descriptions of monetary policy (discretion, commitment or a simple rule) after allowing for Markov switching in policy maker preferences and shock volatilities. This reveals that there have been several changes in Euro area policy making, with a strengthening of the anti-inflation stance in the early years of the ERM, which was then lost around the time of German reunification and only recovered following the turnoil in the ERM in 1992. The ECB does not appear to have been as conservative as aggregate Euro-area policy was under Bundesbank leadership, and its response to the financial crisis has been muted. The estimates also suggest that the most appropriate description of policy is that of discretion, with no evidence of commitment in the Euro-area. As a result although both ‘good luck' and ‘good policy' played a role in the moderation of inflation and output volatility in the Euro-area, the welfare gains would have been substantially higher had policy makers been able to commit. We consider a range of delegation schemes as devices to improve upon the discretionary outcome, and conclude that price level targeting would have achieved welfare levels close to those attained under commitment, even after accounting for the existence of the Zero Lower Bound on nominal interest rates