International Macroeconomics and Finance: Theory and Empirical Methods Nelson C. Mark December 12, 2000 forthcoming, Blackwell Publishers i To Shirley, Laurie, and Lesli ii Preface This book grew out of my l ecture notes for a graduate course in in- ternational macro economics and Þnance that I teach at the Ohio State University. The book is targeted towards second year graduate stu- dents in a Ph.D. program. The material is accessible to those who have completed core courses in statistics, econometrics, and macroeconomic theory typically taken in the Þrst year of graduate study. These days, there is a high level of interaction between empirical and theoretical research. This book reßects this healthy development by integrating both theoretical and empirical issues. The theory is in- troduced by developing the canonical model in a topic area and then its predictions are evaluated quantitatively. Both the calibration method and standard econometric methods are covered. In many of the empir- ical applications, I have updated the data sets from the original studies and have re-done the calculations using the Gauss programming lan- guage. The data and Gauss programs will be available for downloading from my website: www.econ.ohio-state.edu/Mark. There are several different ‘camps’ in international m acroeconomics and Þnance. One of the major divisions is between the use of ad hoc and optimizing models. The academic research frontier stresses the theoretical rigor and internal consistency of fully articulated general equilibrium models with optimizing agents. However, the ad hoc mod- els that predate optimizing models are still used in policy analysis and evidently still have something useful to sa y. The book strikes a middle ground by providing coverage of both types of models. Some of the other divisions in the Þeld are ßexible price versus sticky price models, rationality versus irrationality, and calibration versus sta- tistical inference. The book gives consideration to each o f these ‘mini debates.’ Each approach has its good points and its bad points. Al- though many people feel Þrmly about the particular way that research in the Þeld should be done, I believe that beginning students should see a balanced treatment of the different views. Here’s a brief outline of what is to come. Chapter 1 derives some basic relations and gives some institutional background on international Þnancial markets, national income and balance of payments accounts, and central bank operations. iii Chapter 2 collects many of the time-series techniques that we draw upon. It is not necessary work through this chapter carefully in the Þrst reading. I would suggest that you skim the chapter and make note of the contents, then refer back to the relevant sections when the need arises. This chapter keeps the book reasonably self-contained and provides an efficient reference with uniform notation. Many differen t time-series techniques have been implemented in the literature and treatments of the various methods are scattered across different textbooks and journal articles. It would be really unkind to send you to multiple outside sources and require you to invest in new notation to acquire the background on these techniques. Such a strat- egy seems to me expensive in time and money. While this material is not central to international macro economics and Þnance, I was con- vinced not to place this stuff in an appendix by feedback from my own students. They liked having this material early on for three reasons. First, they said that people often don’t read appendices; second, they said that they liked seeing an econometric roadmap of what was to come; and third, they said that in terms of reference, it is easier to ßip pages towards the front of a book than it is to ßip to the end. Moving on, Chapters 3 through 5 cover ‘ßexible price’ models. We begin with the ad hoc monetary model and progress to dynamic equilib- rium models with optimizing agen ts. These models offer limited scope for policy interventions because they are set in a perfect world with no market imperfections and no nominal rigidities. However, they serve as a useful benchmark against which to measure reÞnements and progress. The next two chapters are devoted to understanding two anomalies in international macroeconomics and Þnance. Chapters 6 covers devia- tions from uncovered interest parity (a.k.a. the forward-premium bias), and Chapter 7 covers deviations from purchasing-power parity. Both topics have been the focus of a tremendous amount of empirical work. Chapters 8 and 9 cover ‘sticky-price’ models. Again, we begin with ad hoc versions, this time the Mundell—Fleming model, then progress to dynamic equilibrium models with optimizing agents. The models in these chapters do suggest positive roles for policy interventions be- cause they are set in imperfectly competitive environments with nomi- nal rigidities. Chapter 10 covers the analysis of exchange rates under target z ones. iv We take the view that these are a class of Þxed exchange rate mod- els where th e central bank is committed to keeping the exchange rate within a speciÞed zone, although the framework is actually more gen- eral and works even when explicit targets are not announced. Chapter 11 continues in this direction by with a treatment of the causes and timing of collapsing Þxed exchange rate arrangements. The Þeld of international macroeconomics and Þnance i s vast. Keep- ing the book sufficiently short to use in a one-quarter or one-semester course meant omitting coverage of some important topics. The book is not a literature survey and is prett y short on the history of thought in the area. Man y excellent and inßuential papers are not included in the citation list. This simply could not be avoided. As my late colleague G.S. Maddala once said to me, “You can’t learn anything from a fat book.” Since I want you to learn from this book, I’ve aimed to keep it short, concrete, and to the point. To avoid that ‘black-box’ perception that beginning students some- times have, almost all of the results that I present are derived step-b y- step from Þrst p rinciples. This i s annoying for a knowledgeable reader (i.e., the instructor), but hopefully it is a feature that new students will appreciate. My overall objective is to efficiently bring you up to the research frontier in international macroeconomics and Þnance. I hope that I have achieved this goal in some measure and that you Þnd the book to be of some value. Finally, I would like to express my appreciation to Chi-Young Choi, Roisin O’Sullivan and Raphael Solomon who gave me useful comments, and to Horag Choi and Young-Kyu Moh who corrected innumerable mistakes in the manuscript. My very special thanks goes to Donggyu(1)⇒ Sul who read several drafts and who helped me to set up much of the data used in the book. Contents 1 Some Institutional Background 1 1.1 International Financial Markets 2 1.2 National Accounting Relations 15 1.3 The Central Bank’s Balance Sheet 20 2 Some Useful Time-Series Methods 23 2.1 Unrestricted Vector Autoregressions 24 2.2 Generalized Method of Moments 35 2.3 Simulated Method of Moments 38 2.4 Unit Roots 40 2.5 Panel Unit-Root Tests 50 2.6 Cointegration 63 2.7 Filtering 67 3 The Monetary Model 79 3.1 Purchasing-Power Parity 80 3.2 The Monetary Model of the Balance of Payments 83 3.3 The Monetary Model under Flexible Excha nge Rates 84 3.4 Fundamentals and Ex change Rate Volatility 88 3.5 Testing Monetary Model Predictions 91 4 The Lucas Model 105 4.1 The Barter Economy 10 6 4.2 The One-Money Monetary Economy 113 4.3 The Two-Money Monetary Economy 118 4.4 Introduction to the Calibration Method 125 4.5 Calibrating the Lucas Model 126 v vi CONTENTS 5 International Real Business Cycles 137 5.1 Calibrating the One-Sector Growth Model 138 5.2 Calibrating a Two-Country Model 149 6 Foreign Exchange Market Efficiency 161 6.1 Deviations From UIP 162 6.2 Rational Risk Premia 17 2 6.3 Testing Euler Equations 177 6.4 Apparent Violations of Rationality 183 6.5 The ‘Peso Problem’ 186 6.6 Noise-Traders 193 7 The Real Exchange Rate 207 7.1 Some Preliminary Issues 208 7.2 Deviations from the Law-Of-One Price 209 7.3 Long-Run Determinants of the Real Exchange Rate 213 7.4 Long-Run Analyses of Real Exchange Rates 217 8 The Mundell-Fleming Model 229 8.1 A Static Mundell-Fleming Model 229 8.2 Dornbusch’s Dynamic Mundell—Fleming Model 237 8.3 A Stochastic Mundell—Fleming Model 241 8.4 VAR analysis of Mundell—Fleming 249 9 The New International Macroeconomics 263 9.1 The Redux Model 264 9.2 Pricing to Market 286 10 Target-Zone Models 307 10.1 Fundamentals of Stochastic Calculus 308 10.2 The Continuous—Time Monetary Model 310 10.3 InÞnitesimal Marginal Intervention 313 10.4 Discrete Intervention 319 10.5 Eventual Collapse 320 10.6 Imperfect Target-Zone Credibility 322 CONTENTS vii 11 Balance of Payments Crises 327 11.1 A First-Generation Model 328 11.2 A Second Generation Model 335 Chapter 1 Some Institutional Background This chapter covers some institutional background and develops some basic relations that we rely on in i nternational macroeconomics and Þnance. First, you will get a basic description some widely held in- ternational Þnancial instruments and the markets in which they trade. This discussion allows us to quickly derive the fundamental parity rela- tions implied by the absence of riskless arbitrage proÞts that relate asset prices in international Þnancial markets. These parity conditions are emplo yed regularly in international macroeconomic theory and serve as jumping off points for more in-depth analyses of asset pricing in the in ternational environment. Second, you’ll get a brief overview of the national income accounts and their relation to the balance of payments. This discussion identiÞes some of the macroeconomic data that we want theory to explain and that are employed in empirical work. Third, you will see a discussion of the central bank’s balance sheet—an understand- ing of which is necessary t o appreciate the role of international (foreign exchange) reserves in the central bank’s foreign exchange market inter- vention and the impact of intervention on the domestic money supply. 1 2 CHAPTER 1. SOME INSTITUTIONAL BACKGROUND 1.1 International Financial Markets We begin with a description of some basic international Þnancial instru- ments and the markets in which they trade. As a point of reference, we view the US as the home country. Foreign Exchange Foreign exchange is traded over the counter through a spatially de- centralized dealer network. Foreign currencies are mainly bought and sold by dealers housed in large money center banks located around the world. Dealers hold foreign exchange inventories and aim to earn trad- ing proÞts by buying low and selling high. The foreign exchange market is highly liquid and trading volume is quite large. The Federal Reserve Bank of New York [51] estimates during April 1998, daily volume of for- eign exchange transactions involving the US dollar and executed within in the U.S was 405 billion dollars. Assuming a 260 business day calen- dar, this implies an annual volume of 105.3 trillion dollars. The total volume of foreign exchange trading is much larger than this Þgure be- cause foreign exchange is also traded outside the US—in London, Tokyo, and Singapore, for example. Since 1998 US GDP was approximately 9 trillion dollars and the US is approximately 1/7 of the world economy, the volume of foreign exchange trading evidently exceeds, by a great amoun t, the quantity necessary to conduct international trade. During most of the post WWII period, trading of convertible cur- rencies took place with respect to the US dollar. This meant that converting yen to deutschemarks required two trades: Þrst from yen to dollars then from dollars to deutschemarks. The dollar is said to be the vehicle currency for international transactions. In recent years cross- currency trading, that allows yen and deutschemarks to be exchanged directly, has become increasingly common. The foreign currency price of a US dollar is the exchange rate quoted in European terms. The US dollar price of one unit of the foreign currencyistheexchangerateisquotedinAmerican terms.InAmerican terms, an increase in the exchange rate means the dollar currency has depreciated in value relative to the foreign currency. In this book, we will always refer to the exchange rate in American terms. [...]... Chapter 2 Some Useful Time-Series Methods International macroeconomic and Þnance theory is typically aimed at explaining the evolution of the open economy over time The natural way to empirically evaluate these theories are with time-series methods This chapter summarizes some of the time-series tools that are used in later chapters to estimate and to test predictions by the theory The material is written... normal with mean µ and variance σ 2 and is called the asymptotic distribution of YT This means that for sufficiently large T , the random variable {YT } has the normal distribution with mean µ and variance σ 2 We will say that a time-series {xt } is covariance stationary if its Þrst and second moments are Þnite and are time invariant—for example, if E(xt ) = µ, and E(xt xt−j ) = γj AR(p) stands for autoregression... random variable Xt is independently iid and identically distributed as N (µ, σ 2 ), Xt ∼ (µ, σ 2 ) means that Xt is 1 See Hamilton [66], Hatanaka [74], and Johansen [81] 23 24 (3)⇒ CHAPTER 2 SOME USEFUL TIME-SERIES METHODS independently and identically distributed according to some unspeciD Þed distribution with mean µ and variance σ 2 , YT → N (µ, σ 2 ) indicates that as T → ∞, the sequence of random... q1t and to q2t If ²1t and ²2t are contemporaneously correlated, however, you can’t just shock ²1t and hold ²2t constant 28 CHAPTER 2 SOME USEFUL TIME-SERIES METHODS To deal with these problems, Þrst standardize the innovations Since the correlation matrix is given by R = ΛΣΛ =  where Λ =  √1 σ11 0 Ã 1 ρ ρ 1 ! ,   is a matrix with the inverse of the standard √1 0 σ22 deviations on the diagonal and. .. econometrics covering linear regression theory and is presented without proofs of the underlying statistical theory There are now several accessible textbooks that contain careful treatments of the associated econometric theory. 1 If you like, you may skip this chapter for now and use it as reference when the relevant material is encountered You will encounter the following notation and terminology Underlined variables... stands for autoregression of order p, MA(n) stands for moving average of order n, ARIMA stands for autoregressive-integrated-moving-average, VAR stands for vector autoregression, and VECM stands for vector error correction model 2.1 Unrestricted Vector Autoregressions Consider a zero-mean covariance stationary bivariate vector time-series, q t = (q1t , q2t )0 and assume that it has the p-th order autoregressive... on the International Money Market (IMM) at the Chicago Mercantile Exchange In Britain, futures are traded at the London International Financial Futures Exchange (LIFFE) Some of the currencies traded are, the Australian dollar, Brazilian real, Canadian dollar, euro, Mexican peso, New Zealand dollar, pound, South African rand, Swiss franc, Russian ruble and the yen Second, contracts mature at standardized... payments to be converted into dollars Similarly, debit transactions create a demand for foreign exchange and a supply of dollars As a result, the combined deÞcits on the current account and the capital account can be thought of as the excess demand for foreign exchange by the private (non central bank) sector This combined current and capital account balance is commonly called the balance of payments Under... deÞne a neutral band of activity within which fp can ßuctuate but still present no proÞtable covered interest arbitrage opportunities The neutral-band analysis proceeds by estimating the transactions costs ¯ ¯ C These are then used to compute the bands [f p , fp ] at various points in time Once the bands have been computed, an examination of the proportion of actual fp that lie within the bands can be conducted... that lie within the bands can be conducted Frenkel and Levich estimate τs and τf to be the upper 95 percentile of the absolute deviation from spot and 90-day forward triangular arbitrage τ is set to 1.25 times the ask-bid spread on 90-day treasury bills and they set τ ∗ = τ They examine covered interest parity for the dollar, Canadian dollar, pound, and the deutschemark The sample is broken into three . International Macroeconomics and Finance: Theory and Empirical Methods Nelson C. Mark December 12, 2000 forthcoming,. econometrics, and macroeconomic theory typically taken in the Þrst year of graduate study. These days, there is a high level of interaction between empirical and