Abstract
This paper reexamines the empirical performance of monetary exchange rate models for the dollar/yen exchange rate. We focus on the character of a potential long-run relationship between exchange rates and fundamentals. Using monthly data from 1976:01 to 2007:12 this paper applies a novel time-varying coefficient approach which allows a distinction between breaks in the cointegration vector and instabilities in the adjustment coefficients. We are able to show that most of the observed breakpoints can be traced back to major policy changes or specific economic developments. Our findings also show that macroeconomic fundamentals do matter for the U.S. dollar/Japanese yen exchange rate, but in different ways over different periods of time.
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Notes
β j are elasticities and α is a constant term. m and y are the logarithms of money supply and real income while π t denotes the inflation rate. The interest rate i rates are expressed as percentage.
In Eq. 9, the differences in the inflation rates represent the expected change in the exchange rate according to the UIP.
T denotes trabables and NT non tradeables.
A model that explicitly takes account of risk premia is the portfolio balance model (Branson 1977).
Bai and Perron note that for practical purposes, less than T(T + 1) segments are permissible, for example if a minimum distance between each break may be imposed. In the framework of this paper, breaks are allowed to occur every 6 months.
Note that the direction of cointegration needs not to be known. Regressors containing a deterministic trend are also allowed.
We checked for robustness of our results with a related approach of Gregory and Hansen (1996). They model the changes in the intercept and the slope coefficients by comparison to the first subperiod running from 0 to T 1. The base model is then written as \( {y_{\tau }} = {t_1} + \tau (t) + x_{\tau }^{\prime }{\kappa_1} + x_{\tau }^{\prime }\kappa (t) + z_{\tau }^{\prime }{\delta_1} + z_{\tau }^{\prime }{\delta_j}(t) + {u_{\tau }} \).
In doing so, we have to apply critical values which take account of the number of estimated coefficients. With an eye on the huge number of coefficients used in our estimation we should not rely on the standard critical values provided by the literature. For this reason, we separately run a Monte-Carlo simulation with 10,000 repetitions in order to obtain critical values for our model.
Sarno (2005) identifies the exchange rate disconnect puzzle as one of the key puzzle in exchange rate economics.
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Acknowledgments
We are grateful for valuable comments from the participants of the 69th International Atlantic Economic Conference, March 24–27, 2010, Prague.
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Beckmann, J., Belke, A. & Kühl, M. Cointegration, structural breaks and monetary fundamentals of the Dollar/Yen Exchange. Int Adv Econ Res 17, 397–412 (2011). https://doi.org/10.1007/s11294-011-9315-2
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DOI: https://doi.org/10.1007/s11294-011-9315-2
Keywords
- Structural exchange rate models
- Cointegration
- Structural breaks
- Switching regression
- Time-varying coefficient approach