ACADEMY OF ECONOMIC STUDIESDOFIN 2009

Coord. Prof. Moisa Altar, Ph.D

stud. Ana-Maria Castravete Balaita

IntroductionThe importance of studying the types of shocks that affect the real exchange rate is twofold:

1. Regarding monetary and governmental policies; e.g. justifying or not a controlled nominal exchange rate;

2. Regarding the economic theoretical models that include this variable; e.g. invalidation of the PPP or of the uncovered interest parity hypothesis;

Overview of economic literatureIdentifying permanent and temporary shocks

of the real exchange rate has followed two main directions suring the last two decades:

1.Identifying one permanent and one temporary shock, with the approximation that the former includes real shocks and the latter monetary shocks.Lastrapes (1992), Evans&Lothian (1993), Enders&Lee (1997), Dibooglu and Kutan (2001), Narayan (2008) analyze the shocks on the real rate of the USD with the main trading partners, including in the Blanchard Quah decomposition the time series of nominal exchange rate or inflation in the home and foreign countries;

Overview of economic literature(cont.)2. Identifying different types of monetary and

real shocks that influence the real exchange rate by including in the analysis variables such as government consumption, GDP, monetary aggregates, prices: Clarida &Gali (1994), Rogers (1999), Alexius (2005);

Unlike the previous approach, this allows the identification of various type of real and monetary shocks, which are possibly acting in opposite ways.

Overview of economic literature(cont.)The theoretical models used in the

literature follow two main models:1.The Dornbusch “overshooting” model

(1976), according to which the fluctuations of the real exchange rate in the short run are due to monetary shocks;

2.The Stockman model (1980), according to which the fluctuations in the real exchage rate are caused by real shocks both on the short and long-time horizon.

Identification of the model: types of shocks and variablesThe shocks on the real exchange rate are:

Fiscal shocks – increases of government taxes. Influences the variable “Share of government consumption in GDP”;

Productivity shocks. Influences the “Real GDP” variable;

Preference shocks – changes in preferences of the population towards or away traded goods. Influences the variable “Real exchange rate “;

Monetary shocks. Influences the variable “Consumer Price Index “.

Solving the model: restrictionsThe long-run restrictions are as follows:The productivity, preference and monetary

shocks do not affect the share of government consumption in GDP;

The preference and monetary shocks do not affect real GDP;

The monetary shock does not affect the real variables (share of government consumption, real GDP and consumer preferences)

Solving the model: data• Save for the real RON/EUR exchange rate, the series

are calculated as log differential between the value of the variable in Romania and the value in the Euro zone (Source: Eurostat).

• Frequency: quarterly, over 1998:3 – 2000:3• The differential of government consumption share of

GDP;• The real GDP differential;• Log of real exchange rate;• CPI differential, base July 2000.• Real GDP series and the series of government

consumption share of GDP are deseasonalized (using Tramo/Seats);

Unit root testsSeries ADF test Philips Perron test Conclusion

Level First difference Level First difference

DLGOV-4.582835 -10.27251 -4.555969 -11.93934

I(0)(0.0007) (0.0000) (0.0007) (0.0000)

DLGDP1.148434 -2.787268  0.196695 -6.620463

I(1)(0.9971) (0.0704) (0.9690) (0.0000)

LRER

-0.319777 -4.733657 -0.635424 4.733657

I(1)

(0.9129) (0.0004) (0.8511) (0.0000)

DLCPI

-6.979194

-0.759765 -6.812498 -5.389427

I(0)

(0.0000) (0.9599) (0.0000) (0.0004)

VAR estimationStationarity condition:

Roots of Characteristic Polynomial Endogenous variables: DLGOV DIFDLGDP DIFLRER DLCPI Exogenous variables: C Lag specification: 1 2 Date: 07/01/09 Time: 22:36

Root Modulus 0.918099 0.918099

-0.062073 - 0.573863i 0.577210 -0.062073 + 0.573863i 0.577210 -0.494308 0.494308 0.403856 - 0.205666i 0.453209 0.403856 + 0.205666i 0.453209 -0.237974 0.237974 0.009307 0.009307

No root lies outside the unit circle.

VAR satisfies the stability condition.

VAR estimationNormality of the residuals:

VAR Residual Normality Tests Orthogonalization: Cholesky (Lutkepohl) H0: residuals are multivariate normal Date: 07/01/09 Time: 22:41 Sample: 1998Q4 2008Q3 Included observations: 38

Component Jarque-Bera df Prob. 1 1.619460 2 0.4450

2 4.199317 2 0.1225 3 3.754361 2 0.1530 4 2.789446 2 0.2479

Joint 12.36258 8 0.1357

VAR estimationWhite's test:

VAR Residual Heteroskedasticity Tests: No Cross Terms (only levels and squares) Date: 07/01/09 Time: 22:50 Sample: 1998Q4 2008Q3 Included observations: 38

Joint test: Chi-sq df Prob. 132.4330 160 0.9454 Individual components:

Dependent R-squared F(16,21) Prob. Chi-sq(16) Prob. res1*res1 0.323730 0.628294 0.8268 12.30175 0.7230

res2*res2 0.528570 1.471584 0.2010 20.08567 0.2164 res3*res3 0.267238 0.478669 0.9315 10.15506 0.8584 res4*res4 0.273078 0.493059 0.9234 10.37698 0.8462 res2*res1 0.238095 0.410157 0.9632 9.047624 0.9114 res3*res1 0.259710 0.460454 0.9410 9.868983 0.8734 res3*res2 0.333114 0.655604 0.8037 12.65835 0.6976 res4*res1 0.368407 0.765580 0.7040 13.99948 0.5988 res4*res2 0.290824 0.538238 0.8950 11.05129 0.8063 res4*res3 0.356862 0.728276 0.7387 13.56076 0.6314

Long-run restrictionsThe restrictions are imposed according to the

equation:

Yt =

Impulse Response Functions of the real exchange rate

The response of the change in the real exchange rate to shocksThe relative fiscal shock generates an initial

appreciation of the real exchange rate, indicating that an increase of taxation encourages consumption of non-tradable goods;

The productivity shock generates an appreciation of the real exchange rate which is persistent in the log-run.

The response of the change in the real exchange rate to shocks (cont.)• As expected, the preferences shock generates a

depreciation of the real exchange rate that remains permanent above the level of the initial shock. We notice that the supply shock (previous table) and the demand shock (current table) have contrasting influences over the real exchange rate, thus justifying our approach of using several “real” variables in order to identify various real structural shocks.

The monetary shock generates an initial appreciation of the real exchange rate, indicating price stickiness, which is absorbed within approximately a year.

Variance decompositionHorizon fiscal productivity preference monetary

1 16.6 58.5 16.5 0.9

2.0,48.0 34.5,77.0 6.9,30.4 0.1, 3.5

2 14.2 62.5 16.4 0.5

2.7,42.0 40.4,79.1 6.8,29.4 0.1, 1.5

3 12.9 63.0 16.8 0.4

3.3,40.3 41.2,78.7 7.2,30.5 0.1, 1.0

4 13.0 62.6 17.0 0.3

3.4,39.1 42.4,78.5 7.4,30.4 0.1, 0.8

8 13.8 62.3 16.6 0.2

3.3,40.5 41.5,79.1 6.9,30.0 0.0, 0.4

12 14.1 62.4 16.4 0.1

3.1,43.0 39.7,79.1 6.6,29.8 0.0, 0.3

24 14.1 62.6 16.2 0.1

2.3,44.7 38.5,79.4 6.4,29.7 0.0, 0.2

Variance decomposition (cont.)The largest part of the forecast error variance

is due to the productivity shock, followed by the preference and the fiscal shock;

The monetary shock has an extremely small influence;

The majority of studies of structural shocks affecting the real exchange rate find over 50% of the forecast error variance explained by real (or “permanent”) shocks, although the percentage due to monetary shocks is much larger.

Historical decomposition – fiscal shock

Historical decomposition – productivity shock

Historical decomposition – preference shock

Historical decomposition – monetary shock

Historical decomposition (cont.)the fiscal and preference shocks act in

opposite directions in influencing the RER; during the two main swings of the real path: the preference shock influences towards the depreciation of the RER and the fiscal shock towards appreciation.

Conclusions• The shocks affecting the RON/EUR real

exchange rate are over 95% real in nature;• The real shock with the most important

weight is the productivity shock; the historical decomposition shows that the main changes in the RER are due to this shock;

• The real shocks have contradictory signs, which justifies the inclusion of more than one "real" variable in our model;

Conclusions (cont.)• The results regarding the shocks that

influence the EUR/RON real exchange rate are in line with the findings for the developed countries and also with the results obtained by Dibooglu&Kutan (2001) for Hungary;

• These findings confirm the predictions of the "equilibrium" models over those of the "disequilibrium" models;

References• Alexius, A. (2005). Productivity shocks and real exchange rates.

Journal of Monetary Economics, 52, 555−566.• Blanchard, O. J., & Quah, D. (1989). The dynamic effects of

aggregate demand and supply disturbances. American Economic Review, 79, 655−673.

• Clarida, R., & Gali, J. (1994). Sources of real exchange rate fluctuations: How important are nominal shocks? Carnegie Rochester Series on Public Policy, 41, 1−56.

• Devereux, M. B., & Lane, P. R. (2003). Understanding bilateral exchange rate volatility. Journal of International Economics, 60, 109−132.

• Dibooglu, S., & Kutan, A. M. (2001). Sources of real exchange rate fluctuations in transition economies: The case of Poland and Hungary. Journal of Comparative Economics, 29, 257−275.

• Dornbush, R. (1976). The theory of flexible exchange rate regimes and macroeconomic policy. Scandinavian Journal of Economics, 78, 255−275.

Bibliografie• Enders, W., & Lee, B. -S. (1997). Accounting for

real and nominal real exchange rate movements in the post-Bretton Woods period. Journal of International Money and Finance, 16, 233−254.

• Evans, M. D. D., & Lothian, J. R. (1993). The response of exchange rates to permanent and transitory shocks under floating

• Jang, K., & Ogaki, M. (2004). The effects of monetary policy shocks on exchange rates: A structural vector error correction model approach. Journal of Japanese and International Economies, 18, 99−114.

Bibliografie• Joyce, J. P., & Kamas, L. (2003). Real and nominal determinants of real

exchange rates in Latin America: Short-run dynamics and long-run equilibrium. Journal of Development Studies, 39, 155−182.

• Lastrapes, W. D. (1992). Sources of fluctuations in real and nominal exchange rates. Review of Economics and Statistics, 74,

• 530−539.• Lee, J., & Chinn, M. D. (2006). Current account and real exchange rate

dynamics in the G7 countries. Journal of International• Money and Finance, 25, 257−274.• Messe, R., & Rogoff, K. (1988).Was it real? The exchange rate interest

differential relation over the modern floating rate period.• Journal of Finance, 43, 933−948.• Rogers, J. (1999). Monetary shocks and real exchange rates. Journal of

International Economics, 49, 269−288.• Stockman, A. C. (1980). A theory of exchange rate determination. Journal

of Political Economy, 88, 673−698.• Stockman, A. C. (1987). Equilibrium approach to exchange rates. Federal

Reserve Bank Richmond Economic Review, 73, 12−30.