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 lecture notes for a graduate course in international macroeconomics and Þnance that I teach at the Ohio State University The book is targeted towards second year graduate students 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 introduced 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 empirical applications, I have updated the data sets from the original studies and have re-done the calculations using the Gauss programming language 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 macroeconomics 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 models that predate optimizing models are still used in policy analysis and evidently still have something useful to say 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 statistical inference The book gives consideration to each of these ‘mini debates.’ Each approach has its good points and its bad points Although 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 different 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 strategy seems to me expensive in time and money While this material is not central to international macroeconomics and Þnance, I was convinced 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 equilibrium models with optimizing agents 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 deviations 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 because they are set in imperfectly competitive environments with nominal rigidities Chapter 10 covers the analysis of exchange rates under target zones iv (1)⇒ We take the view that these are a class of Þxed exchange rate models where the central bank is committed to keeping the exchange rate within a speciÞed zone, although the framework is actually more general 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 is vast Keeping 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 pretty short on the history of thought in the area Many 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 sometimes have, almost all of the results that I present are derived step-bystep from Þrst principles This is 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 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 2.1 Unrestricted Vector Autoregressions 2.2 Generalized Method of Moments 2.3 Simulated Method of Moments 2.4 Unit Roots 2.5 Panel Unit-Root Tests 2.6 Cointegration 2.7 Filtering 3 The 3.1 3.2 3.3 3.4 3.5 Monetary Model Purchasing-Power Parity The Monetary Model of the Balance of Payments The Monetary Model under Flexible Exchange Rates Fundamentals and Exchange Rate Volatility Testing Monetary Model Predictions 4 The 4.1 4.2 4.3 4.4 4.5 Lucas Model The Barter Economy The One-Money Monetary Economy The Two-Money Monetary Economy Introduction to the Calibration Method Calibrating the Lucas Model v 23 24 35 38 40 50 63 67 79 80 83 84 88 91 105 106 113 118 125 126 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 6.1 Deviations From UIP 6.2 Rational Risk Premia 6.3 Testing Euler Equations 6.4 Apparent Violations of Rationality 6.5 The ‘Peso Problem’ 6.6 Noise-Traders 7 The 7.1 7.2 7.3 7.4 Real Exchange Rate Some Preliminary Issues Deviations from the Law-Of-One Price Long-Run Determinants of the Real Exchange Rate Long-Run Analyses of Real Exchange Rates 8 The 8.1 8.2 8.3 8.4 Mundell-Fleming Model A Static Mundell-Fleming Model Dornbusch’s Dynamic Mundell—Fleming Model A Stochastic Mundell—Fleming Model VAR analysis of Mundell—Fleming 161 162 172 177 183 186 193 207 208 209 213 217 229 229 237 241 249 9 The New International Macroeconomics 263 9.1 The Redux Model 264 9.2 Pricing to Market 286 10 Target-Zone Models 10.1 Fundamentals of Stochastic Calculus 10.2 The Continuous—Time Monetary Model 10.3 InÞnitesimal Marginal Intervention 10.4 Discrete Intervention 10.5 Eventual Collapse 10.6 Imperfect Target-Zone Credibility 307 308 310 313 319 320 322 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 international macroeconomics and Þnance First, you will get a basic description some widely held international Þnancial instruments and the markets in which they trade This discussion allows us to quickly derive the fundamental parity relations implied by the absence of riskless arbitrage proÞts that relate asset prices in international Þnancial markets These parity conditions are employed regularly in international macroeconomic theory and serve as jumping off points for more in-depth analyses of asset pricing in the international 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 understanding of which is necessary to appreciate the role of international (foreign exchange) reserves in the central bank’s foreign exchange market intervention and the impact of intervention on the domestic money supply 1 2 1.1 CHAPTER 1 SOME INSTITUTIONAL BACKGROUND International Financial Markets We begin with a description of some basic international Þnancial instruments 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 decentralized 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 trading 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 foreign exchange transactions involving the US dollar and executed within in the U.S was 405 billion dollars Assuming a 260 business day calendar, this implies an annual volume of 105.3 trillion dollars The total volume of foreign exchange trading is much larger than this Þgure because 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 amount, the quantity necessary to conduct international trade During most of the post WWII period, trading of convertible currencies 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 crosscurrency 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 currency is the exchange rate is quoted in American terms In American 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 ... theoretical and empirical issues The theory is introduced by developing the canonical model in a topic area and then its predictions are evaluated quantitatively Both the calibration method and standard... background and develops some basic relations that we rely on in international macroeconomics and Þnance First, you will get a basic description some widely held international Þnancial instruments and. .. contain less 52 CHAPTER SOME USEFUL TIME-SERIES METHODS proposed panel unit-root tests have by Levin and Lin [91], Im, Pesaran and Shin [78], and Maddala and Wu [99] We begin with the popular Levin—Lin