monpol_02

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Prof. Reitz International Monetary Policy 1

International Monetary Policy

Topics

1. Introduction

2. A Simple Macro Model of the Open Economy

3. Theory of Optimum Currency Areas

4. International Monetary Arrangements

5. Speculative Attacks and Currency Crisis

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1. Introduction

1.1 Historical Overview1.2 Stylized Facts of Foreign Exchange Markets

1.3 How to move on

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1.2 Stylized facts of foreign exchange markets

1.2.1 Misalignments

1.2.2 Departures from UIP1.2.3 Excess Volatility (exchange rate disconnect)

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1.2.1Misalignments

• Starting point:Purchasing Power Parity (PPP) as a long-run variable

determining the exchange rate

• Logic:In case of internationally integrated goods markets the law of

one price should hold:Price of a basket of goods is the same across currencies

Absolute PPP:

where S t denotes units of domestic currency per unit offoreign currency and P t consumer price indices.

t t t S PP ⋅= *

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Theoretical considerations

• Taking logarithms we find that the absolute PPP is

• and relative PPP

t t t p ps =+ *

t t t t t t

p p p pss −=−+−+++

1

**

11

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Empirical Evidence

• Absolute PPP

• Relative PPP

Literature:

Sarno / Taylor 2002, Chapter 3

Rogoff (1996), JEL

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Empirical evidence on absolute PPP

• Data from the World Bank

• PPP Conversion factors defined as:„ Number of units of a country's currencyrequired to buy the same amounts of goods and

services in the domestic market as an U.S.dollar would buy in the United States. “

∑

∑

=

==

n

i

i

US

i

n

i

i

LCU

i

X P

X P

PPPCF

1

1

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Empirical evidence on absolute PPP

• If absolute PPP holds then the market rate

should equal the PPP conversion rates

• Or, put differently

t t PPPCF S =

100100

!

=⋅t

t

PPPCF

S

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Absolute PPP

PPP conversion factors from the World Bank. Number of units of a country's currencyrequired to buy the same amounts of goods and services in the domestic market as U.S. dollarwould buy in the United States.

PPP conversion factor, GDP (LCU per international $)

Country Nam Australia Canada China Hong Kong S Japan Korea, Rep.

1999 1,29695 1,19081 3,32664815 7,93906316 162,03574 754,892972000 1,31183267 1,23166544 3,32336274 7,48828439 154,752719 745,261516

2001 1,33245369 1,21784343 3,31637996 7,18412328 149,460933 756,8690992002 1,33648985 1,2293335 3,28243433 6,82445445 143,774205 769,77179

2003 1,35196379 1,22626331 3,29709267 6,26945668 139,686953 794,240575

2004 1,36909912 1,23047643 3,42784791 5,88096769 134,374913 795,777493

2005 1,38835579 1,21364403 3,44758984 5,68777967 129,551955 788,9201352006 1,40871 1,20673 3,46538634 5,49265153 124,64489 774,2924

2007 1,42447 1,21032 3,60528262 5,46611217 120,31524 768,42024

2008 1,4782 1,23313 3,80327264 5,42452383 117,02534 785,77537

2009 1,46372 1,19291 3,74548091 114,5756 802,6828

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Absolute PPP

60

80

100

120

140

160

180

200

220

240

260

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

World Bank Absolute PPP Values (against USD)

Australia

Canada

China

Hong Kong

Japan

Korea, Rep.

Norway

Switzerland

United Kingdom

Based on PPP conversion factors from the World Bank. Number of units of a country's currencyrequired to buy the same amounts of goods and services in the domestic market as U.S. dollarwould buy in the United States.

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Empirical Evidence on absolute PPP

• Deviations from absolute PPP may be

substantial and persistent• Deviations seem to be more pronouced vis-á-

vis emerging market economies

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Empirical Evidence on absolute PPP

• Tests for unit roots in real exchange rates

• Real exchange rate defined as

• Deviations from PPP should be corrected over time

• This is true only if γ 1 is significantly negative!

t t t t p psq −+≡ *

t

n

i

it it t eqqq +∆++=∆ ∑=

−+−

1

1110 γ γ γ

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Data sources: IMF-IFS; ECB

Deviations of Euro Spot Rates from PPP-ValuesMonthly observation, 1999 - 2010 (01.2004 = 0)

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-0.4

-0.3

-0.2

-0.1

-0.0

0.1

0.2

0.3

0.4

0.5USDREAL

GBPREAL

JPYREAL

CHFREAL

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Empirical Evidence

• Tests for unit roots in real exchange rates

ADF-critical value: -2.58

γ 1 Std.err ADF

USD 0.007 0.014 -1.22

GBP 0.026 0.017 -0.74JPY 0.005 0.012 -1.12

CHF 0.014 0.016 -1.21

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Empirical Evidence

• Relative PPP implies that the percentage change ofthe spot rate equals inflation differential

• In a regression

the coefficient γ 1 should be one.

( ) t t t t e p ps +∆−∆+=∆

*

10 γ γ

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Empirical Evidence

• Tests for relative PPP

t-Stat. critical value: 1.96

γ 1 t-Stat. R2

USD 0.744 1.04 0.01

GBP -1.672 3.42 0.07JPY -0.101 0.13 0.01

CHF -0.21 0.82 0.00

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Empirical Evidence

• Relative PPP has to be rejected• Inflation differentials do not explain a

significant fraction of FX volatility

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Data sources: IMF-IFS; ECB

Nominal and Real Euro/USD Exchange RatesMonthly observation, 1999 - 2010 (01.2004 = 0)

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4USDREAL

LNUSD

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Conclusions• PPP (absolute and relative version) is rejected among

industrialized countries in most studies• In long-span studies (Edison, 1987) some evidence of

stationary real exchange rates, but mean reversion isweak

• PPP seems to work for high inflation countries(Frenkel, 1978)

• In general, deviations from PPP are substantial andpersistent

• PPP puzzle: “How can one reconcile the enormousshort-term volatility of real exchange rates with the

extremely slow rate at which shocks appear to dampout?”, Rogoff (1996)

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1.2.2 Departures from UIP

• Starting point:Uncovered interest parity (UIP) is a dynamic short-

run capital market equilibrium, which couldcharacterize the degree of capital marketintegration

• Argumentation:In case of integrated capital markets asset returnsshould equalized across currencies:

[ ]1

*

+∆+=

t t t t

s E ii

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1.2.2 Departures from UIP• Under Rational Expectations:

• If UIP and Rational Expectations valid:

• Implies that ex post percentage appreciation of the foreigncurrency equals its interest disadvantage!

[ ] ...~, 1111 d iiss E t t t t t ++++ += ε ε

1

*

1 ++ +−=− t t t t t iiss ε

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Empirical Evidence (Monthly Data)

• Estimated Equation:

• Data set containing interest rates (3-month Libor)

and FX rates – Euro Area, US, UK, Japan, Switzerland, Sweden, Norwegian

– Jan. 1999 to Dec. 2010

– Source: ECB and Bundesbank

( )!1;0:

4 / )(100

0

*

,3,33

==

+−+=−⋅−−−

β α

ε β α

H

iiss t t t t t t t

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Empirical Evidence (Monthly Data)

Interest Differentials and Spot Returns

Monthly observation, 1999 - 2010

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-15

-10

-5

0

5

10

15

20 DLNUSD

DIFFUSD

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Empirical Evidence (Monthly Data) Euro / USD

Linear Regression - Estimation by Least Squares

With Heteroscedasticity-Consistent (Eicker-White) Standard ErrorsDependent Variable DLNUSDMonthly Data From 1999:04 To 2010:12Usable Observations 141 Degrees of Freedom 139Centered R**2 0.015577 R Bar **2 0.008495Durbin-Watson Statistic 0.556519

Variable Coeff Std Error T-Stat Signif*******************************************************************************

1. Constant -0.500389593 0.503805308 -0.99322 0.320602672. DIFFUSD{3} -0.464134360 0.335626638 -1.38289 0.16669893

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Empirical Evidence (Monthly Data) Euro / GBP


With Heteroscedasticity-Consistent (Eicker-White) Standard ErrorsDependent Variable DLNGBPMonthly Data From 1999:04 To 2010:12Usable Observations 141 Degrees of Freedom 139Centered R**2 0.010563 R Bar **2 0.003444Durbin-Watson Statistic 0.663035


1. Constant -1.083310921 0.690819374 -1.56815 0.116845282. DIFFGBP{3} -0.439200712 0.351966164 -1.24785 0.21208627

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Empirical Evidence (Monthly Data) Euro / CHF


With Heteroscedasticity-Consistent (Eicker-White) Standard ErrorsDependent Variable DLNCHFMonthly Data From 1999:04 To 2010:12Usable Observations 141 Degrees of Freedom 139Centered R**2 0.050613 R Bar **2 0.043783Durbin-Watson Statistic 0.886942


1. Constant 1.915835374 0.773007544 2.47842 0.013196662. DIFFCHF{3} -0.999931254 0.502224759 -1.99100 0.04648050

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Empirical Evidence (Monthly Data) Euro / SEK


With Heteroscedasticity-Consistent (Eicker-White) Standard ErrorsDependent Variable DLNSEKMonthly Data From 1999:04 To 2010:12Usable Observations 141 Degrees of Freedom 139Centered R**2 0.125393 R Bar **2 0.119101Durbin-Watson Statistic 0.801130


1. Constant -0.204531880 0.230998759 -0.88542 0.375927912. DIFFSEK{3} -0.549075831 0.103942448 -5.28250 0.00000013

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Empirical Evidence (Monthly Data) USD / GBP


With Heteroscedasticity-Consistent (Eicker-White) Standard ErrorsDependent Variable DLNGBPUSDMonthly Data From 1999:04 To 2010:12Usable Observations 141 Degrees of Freedom 139Centered R**2 0.011418 R Bar **2 0.004306Durbin-Watson Statistic 0.434053


1. Constant 0.4685053077 0.4577579803 1.02348 0.306081812. DIFFUSDGBP{3} 0.4541870573 0.3870619593 1.17342 0.24062658

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Empirical Evidence (Monthly Data) USD / JPY


With Heteroscedasticity-Consistent (Eicker-White) Standard ErrorsDependent Variable DLNJPYUSDMonthly Data From 1999:04 To 2010:12Usable Observations 141 Degrees of Freedom 139Centered R**2 0.025333 R Bar **2 0.018321Durbin-Watson Statistic 0.648349

Variable Coeff Std Error T-Stat Signif*******************************************************************************1. Constant 1.935917885 0.746269068 2.59413 0.009483102. DIFFUSDJPY{3} -0.407507311 0.195779105 -2.08146 0.03739138

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Empirical Evidence (Monthly Data) USD / CHF


With Heteroscedasticity-Consistent (Eicker-White) Standard ErrorsDependent Variable DLNCHFUSDMonthly Data From 1999:04 To 2010:12Usable Observations 141 Degrees of Freedom 139Centered R**2 0.032209 R Bar **2 0.025247Durbin-Watson Statistic 0.726200

Variable Coeff Std Error T-Stat Signif*******************************************************************************1. Constant 1.900960632 0.744183602 2.55442 0.010636362. DIFFUSDCHF{3} -0.635871248 0.287830701 -2.20918 0.02716178

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Prof. Reitz FX markets - Theory and Empirics 32

Exchange rates and international capital markets

• UIP explains only a very small fraction of exchange ratevolatility

• Deviations from UIP are substantial and persistent• UIP is unable to predict the sign of future FX returns

• Risk premia tend to be unable to explain the magnitude

and volatility of FX excess returns

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PD Dr. Reitz Int. Währungspolitik WS 06/07 33

1.2.3 Excess Volatility (exchange rate disconnect)• Starting point:

– Volatility of the economic system is driven by

exogenous shocks!Fixing a single variable in the system increasesvolatility of at least one other variable!

– Flexible exchange rates stabilizes the time pathof macro variables

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Excess Volatility• Simple FX market diagram:

S

∆Exflex

∆Exfix

$D $S $S

Sfix

Sflex

Dollars

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Excess Volatility• Example:

– Exogenous Shock: Disposable income in the

US increases! → Ya ↑ → Ima ↑ → $S↑

• Fixed exchange rates:Ex ↑ um ∆Exfix → (Yr * P) ↑ (implying a major business cycle shock!)

• Flexible exchange rates:

$S↑ → S ↓ → Ex ↑ um ∆Exflex → (Yr * P) ↑(implying a minor business cycle shock!)

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Excess VolatilityComparing fixed vs. flexible exchange rates

• Fixed exchange rates: – Strong transmission of business cycle shocks

– Increased volatility of domestic macro variables

– Zero volatility of exchange rates

• Flexible exchange rates:

– Some isolation from foreign developments

– Less transmission of business cycle shocks – Lower volatility of domestic macro variables

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Textbooks suggests that

• Since financial markets are perceived to absorb

shocks in an efficient way, FX markets should dealwith upcoming volatility

• What is the empirical evidence on this suggestion?

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Exchange rate volatility

-10,00

-8,00

-6,00

-4,00

-2,00

0,00

2,00

4,00

6,00

8,00

10,00

12,00

1 9 5 8

Q 1

1 9 6 0

Q 4

1 9 6 3

Q 3

1 9 6 6

Q 2

1 9 6 9

Q 1

1 9 7 1

Q 4

1 9 7 4

Q 3

1 9 7 7

Q 2

1 9 8 0

Q 1

1 9 8 2

Q 4

1 9 8 5

Q 3

1 9 8 8

Q 2

1 9 9 1

Q 1

1 9 9 3

Q 4

1 9 9 6

Q 3

1 9 9 9

Q 2

2 0 0 2

Q 1

2 0 0 4

Q 4

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Inflation

-1,00

-0,50

0,00

0,50

1,00

1,50

2,00

2,50

3,00

3,50

1 9 5 8 Q 1

1 9 6 0 Q 3

1 9 6 3 Q 1

1 9 6 5 Q 3

1 9 6 8 Q 1

1 9 7 0 Q 3

1 9 7 3 Q 1

1 9 7 5 Q 3

1 9 7 8 Q 1

1 9 8 0 Q 3

1 9 8 3 Q 1

1 9 8 5 Q 3

1 9 8 8 Q 1

1 9 9 0 Q 3

1 9 9 3 Q 1

1 9 9 5 Q 3

1 9 9 8 Q 1

2 0 0 0 Q 3

2 0 0 3 Q 1

2 0 0 5 Q 3

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GDP growth

-6,00

-4,00

-2,00

0,00

2,00

4,00

6,00

8,00

1 9 5 8 Q 1

1 9 6 0 Q 3

1 9 6 3 Q 1

1 9 6 5 Q 3

1 9 6 8 Q 1

1 9 7 0 Q 3

1 9 7 3 Q 1

1 9 7 5 Q 3

1 9 7 8 Q 1

1 9 8 0 Q 3

1 9 8 3 Q 1

1 9 8 5 Q 3

1 9 8 8 Q 1

1 9 9 0 Q 3

1 9 9 3 Q 1

1 9 9 5 Q 3

1 9 9 8 Q 1

2 0 0 0 Q 3

2 0 0 3 Q 1

2 0 0 5 Q 3

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Growth of imports

-8,00

-4,00

0,00

4,00

8,00

12,00

16,00

1 9 5 8 Q 1

1 9 6 0 Q 3

1 9 6 3 Q 1

1 9 6 5 Q 3

1 9 6 8 Q 1

1 9 7 0 Q 3

1 9 7 3 Q 1

1 9 7 5 Q 3

1 9 7 8 Q 1

1 9 8 0 Q 3

1 9 8 3 Q 1

1 9 8 5 Q 3

1 9 8 8 Q 1

1 9 9 0 Q 3

1 9 9 3 Q 1

1 9 9 5 Q 3

1 9 9 8 Q 1

2 0 0 0 Q 3

2 0 0 3 Q 1

2 0 0 5 Q 3

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Growth of exports

-6,00

-4,00

-2,00

0,00

2,00

4,00

6,00

8,00

10,00

12,00

14,00

1 9 5 8 Q 1

1 9 6 0 Q 3

1 9 6 3 Q 1

1 9 6 5 Q 3

1 9 6 8 Q 1

1 9 7 0 Q 3

1 9 7 3 Q 1

1 9 7 5 Q 3

1 9 7 8 Q 1

1 9 8 0 Q 3

1 9 8 3 Q 1

1 9 8 5 Q 3

1 9 8 8 Q 1

1 9 9 0 Q 3

1 9 9 3 Q 1

1 9 9 5 Q 3

1 9 9 8 Q 1

2 0 0 0 Q 3

2 0 0 3 Q 1

2 0 0 5 Q 3

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First impression:

• Performance of FX markets / flexible exchangerates seems to be disappointing

• Policy makers do not fully trust FX markets

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There is an extensive literature, for example, onspeculative bubbles, herding, fads, and other behavior

which can drive market prices away from their equilibrium

values, even in a market which is deep and liquid.

When such overshooting occurs, intervention may help in

limiting the move or returning the exchange rate towards

its equilibrium level, thus obviating the need for costly

adjustment by the real economy to the incorrect signalswhich the exchange rate would otherwise give.

(Reserve Bank of Australia, 2008)

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First impression:

• Performance of FX markets / flexible exchangerates seems to be disappointing

• Policy makers do not fully trust FX markets

• In fact, Calvo and Reinhart (2002) suggest thatthere is some “fear of floating” among policy

makers

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IMF Annual report on exchange arrangements andexchange restrictions, 2010:

Exchange Rate Regime # countries

Fixed exchange rates(Dollarisation, Curr. Board, Hard pegs

88

Target zones 11

Managed floating (occational intervention) 54

Pure floating 34 (amongthese areUK,US,J,AUS)

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1. Introduction

1.1 Historical Overview

1.2 Stylized Facts of Foreign Exchange Markets

1.3 How to move on

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monpol_02

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