Exchange Rate Economics: Theories and Evidence

Currency substitution and portfolio balance models 197
(US) bond (this is why the labelling is perhaps a little confusing) and therefore the
coefficient on (b ∗ −f ) t should have a negative sign if the above modelling strategy is
appropriate. The signs on money,income,interest rates and the inflation rate are
all correct,although only the last-mentioned term is statistically significant. The
risk premium term,(b ∗ − f ) t ,although statistically significant is wrongly signed:
an increase in the foreign asset relative to the home bond leads to an exchange
rate depreciation,in contrast to the prior expectation. Thus,Frankel’s estimates,
at best,give somewhat mixed support to the portfolio balance approach.
A version of equation (7.63) has also been estimated by Hooper and Morton
(1983) for the dollar effective exchange rate over the period 1973.II–1978.IV and
they found that the risk premium term,assumed a function of the cumulated
current account surplus (net of the cumulation of foreign exchange intervention)
was neither significant nor correctly signed. However,both Blundell-Wignall and
Browne (1991) and Cushman et al. (1997) find statistically significant exchange rate
influences from cumulated current account balances.
The above-noted tests of the portfolio model all use ‘in-sample’ criteria to assess
the model’s performance. In addition to testing the out-of-sample performance
of the monetary models considered in Chapter 9,Meese and Rogoff (1983) also
assessed the out-of-sample forecasting performance of the portfolio model represented
by equation (7.63) (see Chapter 6 for details of the Meese and Rogoff
methodology). In common with their findings for the simple monetary models,Meese
and Rogoff demonstrated that the portfolio balance variant of the
equation was unable to beat the simple random walk. However,it is important to
re-emphasise the point made in Chapter 6 that this could simply reflect the failure
to take account of the underlying data dynamics. 16
Cushman (2006) tests the portfolio balance model for the Canadian–US
exchange rate using better asset data than in most of the earlier studies,discussed
above,and he also addresses non-stationarity issues,using the methods
of Johansen (1995) (none of the studies discussed above address issues arising from
the non-stationarity of the data). The empirical implementation of the model produces
two statistically significant cointegrating vectors,which are shown to be close
approximations for the home and foreign asset demand functions of the theoretical
model. The cointegrating relationships are then used to build a parsimonious error
correction model which is shown to outperform a random walk in an out of sample
forecasting exercise.
A somewhat different approach to assessing the validity of the portfolio model
than using in-sample or out-of-sample criteria,is that proposed by Obstfeld (1982).
He proposes estimating a four equation structural version of the portfolio model
for the deutschmark–US dollar exchange rate over the period 1975–81 (the four
equations are for money demand,money supply and home and foreign bond
market equilibrium). The idea is to simulate the model over the sample period,
under conditions of perfect foresight,and assess whether sterilized intervention
(which amounts to a swap of domestic bonds for foreign bonds,with no implication
for the money supplies in the home or foreign countries) would have been successful.
If the portfolio balance model is appropriate such intervention should be effective