Exchange Rate Economics: Theories and Evidence

Real exchange rate determination 207
Relatedly,Johansen and Juselius (1990) and MacDonald and Marsh (1997) find
that when PPP is tested jointly with UIP,again using Johansen methods,strong
evidence of cointegration is found (up to two significant vectors) which is evidence
supportive of a relationship between real exchange rates and real interest rates.
MacDonald and Nagayasu (2000) use the panel cointegration methods of
Pedroni to test the constant real equilibrium exchange rate variant of real interest
rate parity. A panel of 14 industrialised countries relative to the US is used for the
period 1976–97. Clear evidence in favour of the constant equilibrium variant of
the RERI model is reported,in the sense of the existence of a cointegrating relationship
and estimated slope coefficients which are in conformity with the model
(are inversely related to maturity yield of the underlying bonds). Using a different
panel approach Chortareas and Driver (2001),however,find no evidence of a
long-run relationship in the context of a panel data set.
A number of researchers allow ¯q t to systematically change over time in response
to, inter alia,productivity effects,fiscal imbalances,net foreign asset accumulation
and terms of trade effects. The theoretical justification for the inclusion of these
kinds of variables is taken from the kind of model discussed in Section 8.1. As in
the estimates of the constant equilibrium variant of the model,the estimator used
is important in determining the RERI link. Using the Engle–Granger two-step
estimator,Meese and Rogoff (1988),Edison and Pauls (1993) and Coughlin and
Koedjik (1990) fail to find any evidence of cointegration. For example,Coughlin
and Koedjik (1990) sequentially regress the real exchange rate on the various
candidates noted above and find no evidence of a cointegrating relationship for six
bilateral real exchange rates. In contrast,using multivariate cointegration methods,
Meese and Rogoff (1988) also find no evidence of cointegration and,additionally,
confirm that their celebrated dictum that nominal exchange rate models cannot
outperform a random walk,also holds for real rates.
In contrast to the above,Throop (1992),Edison and Melick (1995),MacDonald
(1997) and Clark and MacDonald (1998) find clear evidence of cointegration in
RERI relationships which allow ¯q t to systematically vary over time. For example,
Throop (1992) uses both a two-step estimator and a dynamic error correction
model,over the period 1982 quarter 1 to 1990 quarter 3,to reveal significant
evidence of cointegration in systems containing the effective US dollar,and the
US bilaterals of the yen,the mark and the pound sterling. Interestingly,the US
effective is shown to dominate a random walk,in an out-of-sample forecasting
contest,at horizons of one to eight quarters; however,the evidence for bilaterals
is more mixed – in one-half of the horizons it is able to beat a random walk. Using
the multivariate cointegration methods of Johansen (1995),Edison and Melick
(1995) find some evidence of cointegration between real interest rates and bilateral
real exchange rates,although they demonstrate that the cointegration result arises
from the stationarity of the real interest differential. MacDonald (1997) also uses
the Johansen cointegration estimation method and produces clear evidence of
a significant cointegrating relationship for the effective rates of the mark,yen
and dollar. Furthermore,these are shown to produce dynamic real exchange rate
models capable of outperforming a random walk at horizons as short as 2 quarters.