Exchange Rate Economics: Theories and Evidence

288 The new open economy macroeconomics part 2
Ghironi et al. (2003) test a two-country variant of the NOEM model in which
cross-country differences in net foreign asset and consumption dynamics are driven
by differences in discount factors and steady-state levels of productivity. Their simulation
results show that even small and empirically plausible differences in discount
factors can impart considerable heterogeneity into net foreign asset positions,and
system dynamics,following productivity shocks. In the empirical implementation
of their model,Ghironi et al. focus on the G3 – Germany,Japan and the US –
against the aggregate of the G7 (excluding the home country). A VAR-based
approach is used,for a sample period spanning 1977,quarter 1 to 1997,quarter 4,
and the key variables included are labour productivity,per capita consumption and
net foreign assets. Standard identification methods are used to identify countryspecific
and global productivity shocks. Ghironi et al.’s empirical results show that
the dynamic responses of net foreign assets and consumption vary considerably
across the G3 and they also argue that the empirical response of the US data are
consistent with those of the less patient more productive economy.
Perhaps the most direct test of the NOEM class of models has been provided by
Bergin (2004) who estimates,using maximum likelihood methods,a two-country
version of the NOEM. The two ‘countries’ are the US against an aggregate of
the rest of the G7 and the variables entering the model are the exchange rate,
the current account,output growth,inflation and interest rate deviations; data
are quarterly over the period 1973:1 to 2000:4. Bergin demonstrates that the onestep-ahead
in-sample predictions for the exchange rate and the current account
are able to beat a random walk,although they are not able to beat the predictions
from a standard VAR model. The estimated parameter estimates from the model
help to shed some light on some of the issues that have arisen in the NOEM class of
models. For example,Bergin finds that a very high degree of local currency pricing
(see Section 11.2) is needed to explain the actual exchange rate movements in the
data set. Bergin also demonstrates that the elasticity of substitution between home
and foreign goods is close to unity,which is the value often assumed in theoretical
work. Bergin also shows that deviations from UIP are very closely correlated with
shocks to marginal utility rather than to monetary shocks,which is at odds with
the basic story in many variants of the NOEM.