Empirical Analysis of Exchange Rates

• Author: Hamid Faruqee
• Pages: 2-3

Page 2

The IMF has established a long tradition of research and operational work to better understand exchange rate behavior, advise countries on exchange rate policy, and assess the prevailing alignment of currencies. ¹ A major applied component of this research has been the development of a multilateral framework for exchange rate assessment. ² In the latest installment of this work, Isard and others (2001) provide an update of the "macrobalance approach" which examines the consistency of exchange rates with medium-term "fundamentals" through the lens of internal and external balance. ³ Internal balance relates to an economy operating at potential output, while external balance refers to an equilibrium saving-investment balance. Thus, the IMF framework for exchange rate assessment relies heavily on current account assessments-the analysis of which has recently been extended to cover a large set of countries, including emerging market economies. ⁴

After Meese and Rogoff (1983) set the bar for evaluating empirical exchange rate models, many studies have undertaken the frustrating, if not futile, attempt to outperform a random walk in terms of forecasting accuracy. ⁵ While success at explaining short-term movements remains elusive, empirical models of exchange rates have fared better over longer time horizons. Tests of the monetary approach to exchange rate determination, for example, have shown some success at long-horizon forecasts, though not without controversy. ⁶ Based on a simulation study of earlier work, Berkowitz and Giorgianni (2001) find little support for long-horizon predictability of the monetary model among the major currencies, except in rare cases where short-run predictability was also evident . ⁷

Another popular empirical approach relies on uncovered interest rate parity, wherein expected changes in the (log) exchange rate correspond, one-for-one, to interest rate differentials. Testing this relationship at both short and long horizons, Chinn and Meredith (2001a, 2001b) obtain sensible coefficients in the latter context with G-7 data, while Flood and Rose (forthcoming) report results that are decidedly mixed for a broader set of countries at higher frequencies. ⁸ MacDonald and Nagayasu (2000) uncover evidence of a long-run connection between real interest rate differentials and real exchange rates in a panel of 14 industrial countries, suggesting that countries with relatively high real interest rates tend to have relatively weak or depressed real exchange rates. ⁹

Testing the validity of purchasing power parity (PPP) as a benchmark for exchange rate behavior has also received considerable attention from researchers. ¹⁰ More recently, studies have sought to explain the so-called "PPP puzzle" (summarized by Rogoff, 1996), around the fact that deviations from PPP are extremely persistent. ¹¹ Chen and Rogoff (2002) find that the terms of trade play a significant role in understanding real exchange rate behavior in Canada, Australia, and New Zealand, though a significant degree of "nagging persist- ence"-that is, the PPP puzzle-remains. ¹² Comparing inter national to intra national real exchange rates, Bayoumi and MacDonald (1999) find that the former group displays mean-reversion while relative prices within the U.S. and Canada do not, suggesting that the comparative role of nominal versus real shocks may help explain these differences. ¹³ Investigating real exchange rate behavior over the business cycle, Chadha and Prasad (1997) identify nominal and real demand shocks (rather than supply shocks) as the primary sources of medium-term variation in Japan's real exchange rate. ¹⁴ MacDonald and Ricci (2001, 2002) find that including sectoral productivity and competitiveness measures in their panel Page 3 estimates substantially reduces the half-life of deviations in the real exchange rate from long-run equilibrium. ¹⁵

Pursuing the issue of long-run equilibrium has led several researchers to consider (stochastic) trends in real exchange rates. Employing a balance of payments framework, a series of papers explore long-run co-movements of real exchange rates with...