Presentation at 15a. school of time series and econometrics in Brazil

1. LONG-RUN EQUILIBRIUM EXCHANGE
RATE IN LATIN AMERICA AND ASIA: A
COMPARISON USING COINTEGRATED
VECTOR
Simone Maciel Cuiabano
15a. Escola de Séries Temporais e Econometria
Teresópolis, 13 de Agosto de 2013.

2. 1. Introduction
• In the wake of the crisis there have been innumerous
talks about currency wars. The comparison among
currencies is important to evaluate to what extent the
gap among nominal exchange rates can be causing
global imbalances.
• The goal of this paper is to find a long-run equilibrium
of the nominal exchange rate among some Latin
American and Asian countries using the flexible price
monetary model described in Obstfeld and Rogoff
(1996).
• This paper uses a panel cointegration analysis to check
the existence of a cointegrated vector among Asia and
Latin America and to estimate the long-run exchange
rate vector capturing the difference between the two
regions using DOLS.

3. 2. Literature Review
• The monetary approach to the exchange rate emerged
as the dominant exchange rate model at the start of the
recent float in the early 1970s. Exchange rate is defined
as the relative price of two currencies and the model
analyses the relative price in terms of the relative
supply of and demand for those currencies.
• The monetary model were dealt a severe blow by the
seminal work of Meese and Rogoff (1983).
• A recent resurgence of empirical work tries to evaluate
exchange rate models using new methods for in-sample
evaluation. In-sample analysis turned to cointegration
to look for long-run relationships between exchange
rates and fundamentals.

4. 2. Literature Review (cont.)
• Evidence for cointegration has been mixed, with results
depending on the country and sample used: MacDonald
and Taylor (1993); Rapach and Wohar (2002).
• Very recent work focuses on using panel cointegration
tests to take advantage of the power of using multiple
country exchange rates and fundamentals. Cerra and
Saxena (2010) found strong evidence for cointegration
between nominal exchange rates and monetary
fundamentals. They also found fundamentals based
models very successful in beating a random walk in
out-of-sample prediction.
• Although the use of panel cointegrating methods has
received great attention, many studies failed in rejecting
the non-cointegration hypothesis. Westerlund (2007)
suggests a structural based test to check panel
cointegration.

5. 3. Theoretical Model
• Obstfeld and Rogoff (1996) describe a discrete money
demand model and use the Keynesian money supply
equation, with PPP and UIP.
• Using purchase power parity (PPP) and uncoverd
interest parity (UIP):
GDPtheis
andindexpricetheisrate,interestnominaltheiswhere)1ln(i
),1(i 1t
y
pii
ypm ttt

 

iilnusingor)1(1UIP
lnusingorPPP
1
*
1t1t
1*
11
**
ttt
t
t
ttt
tttttt
eeEEii
pepPP















6. 3. Theoretical Model (cont.)
• From UIP hypothesis we find the interest rate
differential between countries occurs according to the
currency movement. Substituting in (1):
)()i( 1
**
1t ttttttt
eeEepym  

)i(
11
1 **
1s ssstts
ts
t
pymEe 






 



 



• We find the exchange rate equation in a stochastic
process which shows a positive relation between
money supply and exchange rate and a negative
relation between the GDP and the exchange rate.

7. 3. Theoretical Model (cont.)
• We assume linearity in the parameters and exogeneity
of international interest rate and international prices in
order to approximate the exchange rate as a function of
the other variables.
  *p*iyme ttttt
• In this work we will analyze the equation above to 14
countries in Latin America and Asia using quarterly
data from the first quarter of 1999 untill the first
quarter of 2010.

8. 4. Empirical Analysis
• Period: 1st quarter of 1999 to the 1st quarter of 2010.
• 14 countries accordingly to data availability: Argentina,
Bolivia, Brazil, Chile, Colombia, Mexico and Peru,
China, Indonesia, Hong Kong, Republic of Korea,
Japan, Malaysia and Thailand.
• (I*): USA federal funds rate (Fed Funds).
• (P*): USA consumer price index (CPI).
• (E): average period value of one dollar in local
currency.
• Money supply: base money in local currency seasonally
adjusted.
• Output: GDP in local currency deflated and seasonally
adjusted.
• Source: IFS/IMF.

9. 4. Empirical Analysis (cont.)
• Panel unit root tests => Levin, Lin, and Chu (2002) and
Im, Pesaran, and Shin (2003) have developed panel unit
root tests that allow for heterogeneous dynamics.
Fisher-ADF and Fisher-PP develop a group mean test
that allows for heterogeneity.
• Panel cointegration tests=> panel tests of no
cointegration are essentially panel unit root tests
applied to the residuals of cointegrating regressions.
Kao test follows the same approach as the Pedroni tests
(1999, 2004). Westerlund (2007) proposes four new
panel tests that are based on structural rather than
residual dynamics.
• DOLS => under the assumption of I(1) and
cointegration, DOLS with FE provides an estimate of a
long-run cointegrating relationship.

10. 4. Econometric Analysis (cont.)
• Unit root tests: series are not stacionary.
• Panel unit root tests:
Kao Residual Cointegration Test*
ADF
-1.660
(0.0484)
Pedroni Residual Cointegration Test**
Panel v-Statistic Panel PP-Statistic Panel rho-Statistic Panel ADF-Statistic
-1.982
(0.059)
2.060
(0.047)
2.754
(0.009)
0.962
(0.251)
Group rho-Statistic Group PP-Statistic Group ADF-Statistic
3.188
(0.002)
1.760
(0.084)
1.525
(0.124)
Westerlund Cointegration Test***
Group t Group a Panel t Panel a
-3.005
(0.014)
-6.618
(0.999)
-9.498
(0.089)
-4.886
(0.985)

11. 4. Econometric Analysis (cont.)
Long-run estimation
Variable All Latin America Asia Regional Dummy
Y -0.0105
(0.576)
-0.0315
(0.061)
0.0207
(0.173)
-0.0105
(0.576)
Money -0.0073
(0.460)
-0.0043
(0.689)
-0.0123
(0.360)
-0.0073
(0.460)
I* -0.0252
(0.062)
-0.0634
(0.009)
0.0063
(0.574)
-0.0251
(0.062)
P* -0.2949
(0.001)
-0.5654
(0.000)
-0.0456
(0.457)
-0.2949
(0.001)
Dummy_Asia - - - 8.4340
(0.000)
Constant 1.7342
(0.001)
2.6353
(0.000)
8.8864
(0.000)
1.7342
(0.001)

12. 5. Concluding Remarks
• An increase in money supply and international interest rates are
associated with exchange rate depreciation.
• An increase in GDP and international prices are associated with
an exchange rate appreciation. An increase in GDP attracts
foreign exchange and a larger demand for local currency. An
increase in international prices shift demand to local products,
causing an appreciation in the local currency.
• International prices were significant for Latin America and the
whole model in general and associated with an appreciation of
the exchange rate.
• The dummy for Asia compares the effect of the monetary
policies of the region to Latin America countries. The region is
associated with a depreciation of 8% of its local currency
comparing to LA.

13. 5. Concluding Remarks (cont.)
• This paper verified the existence of a long-run equilibrium of
the nominal exchange rate among some Latin American and
Asian countries using the flexible price monetary model.
• Looking for the long-run nominal exchange rate, in other to
keep equilibrium, either Latin America currencies should be 8%
more depreciated or Asian currencies should be 8% appreciated.
• The estimated coefficients of the monetary model have been
associated with an appreciation of the exchange rate in all the
sample countries. This is clarified if one observes that both
regions have been receiving a great amount of capital flow and
international investment during the period.
• A more flexible monetary policy in Asia should make the
appreciation effect more pronounced in its exchange rate than it
was captured by the model.

14. Literature Review
• Cerra, V., Saxena, S. C.. (2010), The Monetary Model Strikes Back: Evidence from the World. Journal
of International Economics, vol. 81.
• Im, K. S., Pesaram, M. H. (2003), Shin, Y. Testing for Unit Roots in Heterogeneos Panels. Journal of
Econometrics, vol. 115.
• Levin, A. Chu, S. (2002), Unit Root Tests in Panel Data: Asymptotic and Finite Sample Properties,
Journal of Econometrics, 108(1): 1-24.
• MacDonald, R., Taylor, M. (1993), The Monetary Approach to the Exchange Rate: Rational
Expectations, Long-run Equilibrium and Forecasting, IMF Staff Papers, 40:89-107.
• Mark, N. (1995), Exchange Rates and Fundamentals: Evidence on Long-Horizon Predictability.
American Economic Review, 85(1): 201-18.
• Mark, N. C., Sul, D. (2001), Nominal Exchange Rates and Monetary Fundamentals: Evidence from a
Small post-Bretton Woods Panel, Journal of International Economics, Elsevier, vol. 53(1), pages 29-52.
• Meese, R. A., Rogoff, K. (1983), Empirical Exchange Rate Models of the Seventies: Do They Fit Out-
of-sample? Journal of International Economics, 14: 3- 24.
• Obstfeld, M., Rogoff, K. (1996), Foundations of International Macroeconomics. Cambridge, The MIT
Press, chapter 8.
• Pedroni, P. (1999), Critical Values for Cointegration Tests in Heterogeneous Panels with Multiple
Regressors, Oxford Bulletin of Economics and Statistics, 61: 653-70.
• _____________ (2004), Panel Cointegration; Asymptotic and Finite Sample Properties of Pooled Time
Series Tests with an Application to the PPP Hypothesis, Econometric Theory, 20: 597-625.
• Rapach, D.E., Wohar, M. E. (2002), Testing the Monetary Model of Exchange Rate Determination: New
Evidence from a Century of Data, Journal of International Economics, 58(2): 359-385.