Does the Nominal Exchange Rate Regime Affect the Real Interest Parity Condition?

The real interest partity (RIP) condition combines two cornerstones in international finance, uncovered interest parity (UIP) and ex ante purchasing power parity (PPP). The extent of deviation from RIP is therefore an indicator of the lack of product and financial market integration. This paper investigates whether the nominal exchange rate regime has an impact on RIP. The analysis is based on 15 annual real interest rates and covers a long time span, 1870-2006. Four subperiods are distinguished and linked to fixed and flexible exchange rate regimes: the Gold Standard, the interwar float, the Bretton Woods system and the current managed float. Panel integration techniques are used to increase the power of the tests. Cross section correlation is embedded via common factor structures. The results suggest that RIP holds as a long run condition irrespectively of the exchange rate regimes. Adjustment towards RIP is affected by the institutional framework and the historical episode. Half lives of shocks tend to be lower under fixed exchange rates and in the first part of the sample, probably due to higher price flexibility before WWII. Although barriers to foreign trade and capital controls were substantially removed after the collapse of the Bretton Woods system, they did not lead to lower half lives during the managed float.Real interest parity, nominal exchange rate regime, panel unit roots, common factors

Does the Nominal Exchange Rate Regime Affect the Real Interest Parity Condition?

The real interest partity (RIP) condition combines two cornerstones in international finance, uncovered interest parity (UIP) and ex ante purchasing power parity (PPP). The extent of deviation from RIP is therefore an indicator of the lack of product and financial market integration. This paper investigates whether the nominal exchange rate regime has an impact on RIP. The analysis is based on 15 annual real interest rates and covers a long time span, 1870-2006. Four subperiods are distinguished and linked to fixed and flexible exchange rate regimes: the Gold Standard, the interwar float, the Bretton Woods system and the current managed float. Panel integration techniques are used to increase the power of the tests. Cross section correlation is embedded via common factor structures. The results suggest that RIP holds as a long run condition irrespectively of the exchange rate regimes. Adjustment towards RIP is affected by the institutional framework and the historical episode. Half lives of shocks tend to be lower under fixed exchange rates and in the first part of the sample, probably due to higher price flexibility before WWII. Although barriers to foreign trade and capital controls were substantially removed after the collapse of the Bretton Woods system, they did not lead to lower half lives during the managed float.Real interest parity, nominal exchange rate regime, panel unit roots, common factors

A macroeconometric model for the Euro economy

In this paper a structural macroeconometric model for the Eurozone is presented. In opposite to the multi country modelling approach, the model relies on aggregate data on the supra-national level. Due to nonstationarity, all equations are estimated in an error correction form. The cointegrating relations are derived jointly with the short-run dynamics, avoiding the finite sample bias of the two step Engle Granger procedure. The validity of the aggregated approach is confirmed by out-of-sample forecasts and two simulation exercises. In particular the implications of a lower economic recovery in the US and a shock in the nominal Euro area interest rate are discussed.Euro area economy, macroeconometric models, error correction

Does the nominal exchange rate regime affect the real interest parity condition?

The real interest parity (RIP) condition combines two cornerstones in international finance, uncovered interest parity (UIP) and ex ante purchasing power parity (PPP). The extent of deviation from RIP is therefore an indicator of the lack of product and financial market integration. This paper investigates whether the nominal exchange rate regime has an impact on RIP. The analysis is based on 15 annual real interest rates and covers a long time span, 1870-2006. Four subperiods are distinguished and linked to fixed and flexible exchange rate regimes: the Gold Standard, the interwar float, the Bretton Woods system and the current managed float. Panel integration techniques are applied to increase the power of the tests, where cross section correlation is embedded via common factor structures. The results suggest that RIP holds as a long run condition irrespectively of the nominal exchange rate regime. However, adjustment towards RIP is affected by both the institutional framework and the historical episode. Half lives of shocks tend to be lower under fixed exchange rates and in the first part of the sample. Although barriers to trade and capital controls have been removed, they did not lead to lower half lives during the managed float.Real interest parity, nominal exchange rate regime, panel unit roots, common factors

Investigating M3 Money Demand in the Euro Area: New Evidence Based on Standard Models

Monetary growth in the euro area has exceeded its target level especially since 2001. Likewise, recent empirical studies did not find evidence in favour of a stable long run relationship between the variables entering the money demand function. Instead the equation appears to be increasingly unstable if more recent data are included. Since the link between money balances and macroeconomic variables seems to has become rather fragile, these results put serious doubts concerning the rationale of monetary aggregates in the monetary policy strategy of the ECB. However, if the analysis is done without imposing a short run homogeneity restriction between money and prices, a stable long run money demand relationship can be identified, where recursively estimated parameters are almost stable. In addition, the corresponding error correction model survives a wide array of specification tests, including procedures for nonlinearities and parameter instability. Hence, the apparent monetary overhang is in line with standard models of money demand behaviour, and is not expected to lead to a rise in inflation.Cointegration analysis, Error correction, Money demand, Monetary policy

Current Account Imbalances in the Euro Area: Catching up or Competitiveness?

In the debate on global imbalances, the euro area countries did not receive much attention so far. While the current account is on balance for the entire area, divergences between individual member states have increased since the introduction of the common currency. In this paper, the imbalances are traced back to catching up and competitiveness factors using paneleconometric techniques. In line with the intertemporal approach to the current account, low income countries tend to run deficits, while rich countries realize surpluses. However, the effect diminishes, if early years are dropped from the sample. The competitiveness channel is more robust and shows the expected sign, i.e. a real appreciation leads to external deficits. To restore competitiveness, a reduction of unit labour costs is on the agenda. Since a deterioration of competitiveness is not a feasible strategy for the surplus countries, an asymmetric response across countries is required in order to reduce the imbalances.Current account imbalances; catching up and competitiveness; euro area

What Drives Heterogeneity in Foreign Exchange Rate Expectations: Deep Insights from a New Survey

Foreign exchange rate expectations play a central role in virtually all monetary models for the open economy. Therefore, it is extremely important to gain empirical insights into the expectations formation process. In this paper, we use a unique disaggregated data set to model the expectations of the Yen/USD exchange rate of about 50 leading foreign exchange rate professionals. The survey includes not only forecasts of the exchange rate, but also for macroeconomic fundamentals, like GDP growth, inflation, and interest rates. Different expectations of fundamentals might lead to different views of exchange rate dynamics. Using panel models, we are able to confirm the heterogeneity of exchange rate expectations often detected by former authors. More important, we provide strong evidence regarding the likely source of heterogeneity. In line with forward looking models for the exchange rate, expected fundamentals have a substantial impact on exchange rate expectations, thereby challenging the backward looking evidence of previous studies. However, the heterogeneity in the expectations of macroeconomic fundamentals is not sufficient to explain the heterogeneity in exchange rate expectations.Exchange rate expectations, heterogeneity of expectations, expected fundamentals

Drivers of Exchange Rate Dynamics in Selected CIS Countries: Evidence from a FAVAR Analysis

We investigate the likely sources of exchange rate dynamics in selected CIS countries (Russia, Kazakhstan, Ukraine, Kyrgyzstan, Azerbaijan, and Moldova) over the past decade (1999-2008). The analysis is based on country VAR models augmented by a regional common factor structure (FAVAR model). The models include nominal exchange rates, the common factor of exchange rates in the CIS countries, and global drivers such as gold, oil and share prices. Global, regional and idiosyncratic shocks are identified in a standard Cholesky fashion. Based on the decomposition of the variance of forecast errors, their relevance for exchange rates is explored. As a quite robust finding, CIS exchange rates have become more vulnerable to global shocks towards the end of the sample.Exchange rates, CIS countries, financial crisis, FAVAR models

On the Stability of the German Beveridge Curve. A Spatial Econometric Perspective

In this paper, we use the Beveridge relationship to address the effectiveness of the matching process, that brings workers searching for jobs together with employers searching for workers. For a fixed matching technology, the curve yields a negative relation between the unemployment rate and the rate of vacancies. Movements along a curve reflect adjustments over the business cycle. In a recession vacancies are closed, and workers enter the unemployed. Shifts of the curve are more important here, as they point to structural change. For example, an outward shift of the curve indicates an in-creased mismatch, perhaps due to a deterioration in human capital of the unemployed or changes in the unemployment benefit system, which affects the willingness of the un-employed to fill out vacancies. Empirical estimates rely on panel data. A sample of 180 regional labour markets is em-ployed, and the sample period runs from 1993 to 2004. The regional labour markets are seperated on the base of flows of the job commuters and correspond to travel-to-work areas. Due to common or idiosyncratic shocks, however, the cross sections are not inde-pendent. Instead, they are tied together to some extent, and the spillovers account for spatial effects. As these patterns can have an impact on the correlation between unem-ployment and vacancy rates, the results of OLS regressions are eventually biased. Thus the Beveridge curve is efficiently estimated by a spatial procedure, where regional de-pendencies are taken into account. No previous paper has investigated a similar broad regional dataset so far. The eigenfunction decomposition approach suggested by Griffith (1996, 2000) is used to identify spatial and non-spatial components in regression analysis. As the spatial pat-tern may vary over time, inference is conducted on the base of a spatial seemingly unre-lated regressions (spatial SUR) model. Due to this setup, efficient estimates for the Beveridge relationship are obtained. Time dummies are used to control for shifts in the curve. The empirical results provide some indication that the degree of job mismatch has increased over the recent periods.

Money Demand and the Role of Monetary Indicators in Forecasting Euro Area Inflation

This paper examines the forecasting performance of a broad monetary aggregate (M3) in predicting euro area inflation. Excess liquidity is measured as the difference between the actual money stock and its fundamental value, the latter determined by a money demand function. The out-of sample forecasting performance is compared to widely used alternatives, such as the term structure of interest rates. The results indicate that the evolution of M3 is still in line with money demand even in the period of the financial and economic crisis. Monetary indicators are useful to predict inflation at the longer horizons, especially if the forecasting equations are based on measures of excess liquidity. Due to the stable link between money and inflation, central banks should implement exit strategies from the current policy path, as soon as the financial conditions are expected to return to normality.Money demand, excess liquidity, money and inflation