Project funded under the Socio-economic Sciences and Humanities European Commission Does the nominal...

Project funded under the Socio-economic Sciences and Humanities

European Commission

Does the nominal exchange rate regime affect the RIP condition?

Christian Dreger, DIW Berlin

Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X

Contribution of the paper

• RIP combines two cornerstones in international finance: ex ante PPP and UIP– Expected real returns equalised across countries– Deviations indicate lack of market integration

• Previous studies refer to post Bretton Woods

• Impact of nominal exchange rate regime– Real exchange rates behave like nominal rates in

flexible regimes– Independent monetary policies in flexible regimes

• Impact of historical episode: Capital controls and barriers to trade decreased over the past decades


Unit root analysis of RIP

• RIP implies mean reverting of real interest rate differentials (RIDs)

• Time series tests have low power against stationarity in small samples– Evidence mixed in post Bretton woods era

• Longer time periods can invalidate results because of structural breaks

• Solution: Panel unit root analysis– Sources of nonstationarities can be identified


Panel tests of PPP

• Broader information set due to inclusion of cross section – Higher power of tests, lower risk of structural breaks

• More insights: Impact of nominal exchange rate regime can be explored– Mussa (1986) vs Grilli & Kaminsky (1991)

• Evidence might be biased due to cross section dependencies– First generation tests (Levin, Lin & Chu, 2002, IPS,

2004)

• Correlation structures is embedded via common factor structure


Panel tests of PPP (cont‘d)

• IPS (2004) test with mean adjusted data– Cross section correlation via common time effects

• Pesaran (2007) test– ADF extended by cross sectional averages

• Bai and Ng PANIC approach (2004)– RIDs splitted into common and idiosyncratic parts

using PCA– Unit root analysis separately for each component– Common component: time series approach (ADF or

Johansen)– Idiosyncratic component: first generation panel tests


Empirical design

• 14 RIDs relative to US, 4 regimes for nominal exchange rates

• Gold Standard (1870-1914), interwar float (1920-1938), Bretton Woods (1950-1972), managed float (1973-2006)

• Long term nominal interest rates, CPI inflation, from Global Financial Data and Global Insight

• Determination of lag structures, number of factors etc by information criteria


RIDs relative to US

-16

-12

-8

-4

0

4

8

12

70 80 90 00 10 20 30 40 50 60 70 80 90 00

Australia

-40

-30

-20

-10

0

10

20

70 80 90 00 10 20 30 40 50 60 70 80 90 00

Belgium

-12

-8

-4

0

4

8

12

70 80 90 00 10 20 30 40 50 60 70 80 90 00

Canada

-15

-10

-5

0

5

10

15

20

70 80 90 00 10 20 30 40 50 60 70 80 90 00

Denmark

-30

-20

-10

0

10

20

70 80 90 00 10 20 30 40 50 60 70 80 90 00

France

-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

70 80 90 00 10 20 30 40 50 60 70 80 90 00

Germany

-20

-10

0

10

20

30

70 80 90 00 10 20 30 40 50 60 70 80 90 00

Italy

-20

-15

-10

-5

0

5

10

15

20

70 80 90 00 10 20 30 40 50 60 70 80 90 00

Japan


RIDs relative to US (cont‘d)

-20

-15

-10

-5

0

5

10

15

70 80 90 00 10 20 30 40 50 60 70 80 90 00

Netherlands

-12

-8

-4

0

4

8

12

16

20

70 80 90 00 10 20 30 40 50 60 70 80 90 00

Norw ay

-60

-50

-40

-30

-20

-10

0

10

20

30

70 80 90 00 10 20 30 40 50 60 70 80 90 00

Portugal

-20

-15

-10

-5

0

5

10

15

70 80 90 00 10 20 30 40 50 60 70 80 90 00

Spain

-12

-8

-4

0

4

8

12

16

70 80 90 00 10 20 30 40 50 60 70 80 90 00

Sw eden

-12

-8

-4

0

4

8

12

16

20

24

70 80 90 00 10 20 30 40 50 60 70 80 90 00

United Kingdom


Common component of RIDs

-2

0

2

4

6

8

10

75 80 85 90 95 00 05 10

Gold Standard

-4

-3

-2

-1

0

1

2

3

1922 1924 1926 1928 1930 1932 1934 1936 1938

Interwar period

-3

-2

-1

0

1

2

3

4

5

6

52 54 56 58 60 62 64 66 68 70 72

Bretton Woods

-8

-6

-4

-2

0

2

4

6

1975 1980 1985 1990 1995 2000 2005

Managed float


Panel unit root analysis

1870-1914 1920-1938 1950-1972 1973-2006

IPS (2003) -17.19* -5.243* -8.669* -5.884*

Pesaran (2007) -4.838* -2.285* -3.004* -2.544*

Bai and Ng (2004)

Common component (ADF)

-5.136* -3.615* -3.244* -4.606*

Idiosyncratic component (IPS)

-18.11* -2.605* -5.727* -5.580*


Adjustment towards RIP

• Half lives lower for fixed exchange rates (EA), increase after Bretton Woods

1870-1914 1920-1938 1950-1972 1973-2006

AR parameter 0.064 (0.046)

0.232 (0.060)

0.152 (0.056)

0.599 (0.036)

Half-life of shocks 0.252 (0.065)

0.473 (0.082)

0.368 (0.071)

1.352 (0.155)


Conclusions

• RIP valid as a long run condition for all periods– Unit root rejected for common and idiosyncratic

components

• Adjustment towards RIP affected by historical episodes and nominal exchange rate regimes– Half lives lower for fixed exchange rate regime, no real

interest channel available for EA members– Although markets have become more integrated, half

lives are longer for the recent float

• Price stickiness higher after WWII, larger weight of trade in determination of exchange rates

Project funded under the Socio-economic Sciences and Humanities European Commission Does the nominal...

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