TESTING INTERNATIONAL PRICE TRANSMISSION UNDER ...

Empirical Analysis: Cointegration Models Accounting for Policy Regime Changes
5.2.2 Cointegration models accounting for policy regime changes
Based on the theoretical framework outlined in paragraph 4.3, there are other
ways, in addition to the use of a composite variable presented in the previous
paragraph, to further develop it into empirical applications.
Firstly, a particular cointegration model will be estimated, with different
adjustments coefficients depending on the observable policy regimes (Model 2;
paragraph 5.2.2.1). In this first model, the LOP will be imposed to hold between
the French price and the highest between the US and the intervention price.
Secondly, the price transmission elasticity will be allowed to change according to
which price the French one is related to: always, the highest between the
intervention and the US price (Model 3; paragraph 5.2.2.2). Finally, both
adjustment coefficients and the cointegrating vector parameters will be assumed
to vary (Model 4; paragraph 5.2.2.3).
5.2.2.1 Model 2: a threshold model allowing for policy regime changes
All models which follow still stem from the theoretical considerations outlined
in the previous chapter: the French price is assumed to be linked to either the US
or the intervention price depending on which of them is higher.
These models are derived by introducing ad hoc modifications in a general
VECM as presented in equation 3.31 in chapter 3, in order to consider the
influence of policy regimes. If a simple VECM would hold between the US and
the French price, then the LOP would be expected to be valid at least in the long
run, despite prices being allowed to diverge from it in the short run. But such a
straightforward model is clearly not appropriate, as the two variables turn out not
to be cointegrated (see annex C and annex D). In paragraph 5.2.1, we anticipated
that this might due to overlooking the policy regime issue.
For this reason, in Model 2, we try and introduce appropriate modifications to
take policy regimes in due account. We assume that the LOP holds between the
French price and the US price only when the latter is above the intervention price;
otherwise, the LOP will hold between the intervention and the French price 76 .
This is the same as assuming that there are two distinct regimes; this model can be
interpreted as a particular cointegration model in which the adjustment
coefficients take different but non-zero values according to the observable policy
regime the observations belong to.
Technically, this requires the creation of a regime dummy variable, which we
call henceforth regt; if hrwt > pintt, reg t = 1,
and if hrwt < pintt , reg t = 0.
We then estimate the following model:
76 Price spread stationarity (i.e., the validity of the LOP in the long run) is here imposed rather than estimated.
86