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Nominal exchange rates do not move to offset differences in inflation rates on a month to month, quarter to quarter, or even year to year basis, resulting in sizable real exchange rate changes. Are these changes predictable? We address this question in three ways. First, we describe a variety of tests of predictability and explain how the different tests are related. Next, we implement the tests for the U.S. dollar relative to four currencies and find statistically significant evidence that real exchange rate changes are predictable. Finally, we examine whether the predictability is of an economically interesting magnitude.
"This book greatly enhances our understanding of the behavior of real exchange rates. It provides an elegant model based on a solid theoretical foundation that links real exchange rates to their fundamental economic determinants and takes proper account of stock and flow considerations. The authors provide a masterful account of how changes in productivity and thrift affect the real exchange rate, and show that the long-run impact depends crucially on whether the change reflects the former fundamental (investment) or the latter (consumption). The empirical implementation uses state-of-the-art cointegration and error correction methodologies that are eminently well suited to capture the short-run adjustment of the real exchange rate to its medium- to long-run equilibrium value. The empirical results are extremely encouraging, as the economic fundamentals identified by the authors can explain a substantial part of the movement in the real exchange rate of a number of countries."--Peter Clark, International Monetary Fund
This paper documents two facts about the behavior of floating exchange rates in countries where monetary policy follows a Taylor-type rule. First, the current real exchange rate is highly negatively correlated with future changes in the nominal exchange rate at horizons greater than two years. This negative correlation is stronger the longer is the horizon. Second, for most countries, the real exchange rate is virtually uncorrelated with future inflation rates both in the short and in the long run. We develop a class of models that can account for these and other key observations about real and nominal exchange rates.
Textbook, research papers on international economic theory, economic policy and practice - includes a literature survey of theoretical studies in trade relations; covers evolution of economic models explaining the determinants of trade structure, capital flow, labour mobility, trade in natural resources, etc.; examines macroeconomics aspects of balance of payments, exchange rate, international monetary system, economic relations and dependence, etc. Bibliography, graphs, statistical tables.
Several authors have recently investigated the predictability of exchange rates by fitting a sequence of long-horizon error-correction regressions. By considering the implied vector error-correction model, we show that little is to be gained from estimating such regressions for horizons greater than one time period. We also show that in small to medium samples the long-horizon procedure gives rise to spurious evidence of predictive power. A simulation study demonstrates that even when using this technique on two independent series, estimates, diagnostic statistics and graphical evidence incorrectly suggest a high degree of predictability of the dependent variable.
This paper presents a reduced-form model of the real exchange rate. Using multilateral cointegration methods, the model is implemented for the real effective exchange rates of the dollar, the mark, and the yen, over the period 1974-1993. In contrast to much other research using real exchange rates, there is evidence of significant and sensible long-run relationships for a simplified version as well as for the full version of the model. The estimated long-run relationships are used to produce dynamic equations, which outperform a random walk and produce sensible dynamic patterns in the context of an impulse response analysis.
The NBER Macroeconomics Annual provides a forum for important debates in contemporary macroeconomics and major developments in the theory of macroeconomic analysis and policy that include leading economists from a variety of fields. The papers and accompanying discussions in NBER Macroeconomics Annual 2007 address exchange-rate models; implications of credit market frictions; cyclical budgetary policy and economic growth; the impacts of shocks to government spending on consumption, real wages, and employment; dynamic macroeconomic models; and the role of cyclical entry of new firms and products on the nature of business-cycle fluctuations and on the effects of monetary policy.
This paper discusses exchange rate issues in advanced and in developing countries. For the determination of exchange rates among industrialized countries the key question is the following: What is the right framework -- the monetary approach, the equilibrium approach, the new classical approach or the macroeconomic model in the tradition of Mundell-Fleming. To shed light on that question two empirical problems are considered: What is known about the behavior of real exchange rates and how well do alternative models explain the relation among interest rates, expected depreciation and actual depreciation. The second half of the paper discusses real exchange rates in developing countries. This strand of literature has become important in the context of adjustment programs. We focus on the relation between real exchange rates and the profitability of capital. The model highlights the sharp discrepancy between the mobility of capital (even physical capital, in the long run) and the immobility of labor.
One aim of this book is to examine the causes of fluctuations in the mark/dollar, pound/dollar, and yen/dollar real exchange rates for the period 1972-1994 with quarterly data to determine appropriate policy recommendations to reduce these movements. A second aim is to investigate whether the three real exchange rates are covariance-stationary or not and to which extent they are covariance-stationary, respectively. These aims are reached by using a two-country overshooting model for real exchange rates with real government expenditure and by applying Johansen's maximum likelihood cointegration procedure and a factor model of Gonzalo and Granger to this model.