Exchange Rate Economics: Theories and Evidence

Notes 397
10 Thus on this definition a test of whether CIP holds or not would be a test of perfect
capital mobility.
11 Skewness relates to the third moment of the distribution.
12 In order to check that the significant ARCH/GARCH effects are not a reflection of
mispecified models for the conditional mean,Diebold and Nason (1990) and Meese
and Rose (1991) use non-linear methods to show that the model-based exchange rate
forecasts cannot outperform a martingale.
13 Hausman et al. (2004) demonstrate that the real exchange rates of developing countries
are approximately three times more volatile than the real exchange rate of industrial
countries and that the difference in volatility across developing and developed countries
cannot be explained by the larger shocks (both real and nominal) facing developing
countries nor in their susceptibility to currency crises.
14 In the post-1997 period the IMF has significantly revised and upgraded its official
approach to classifying exchange rate arrangements.
15 As Reinhart and Rogoff (2002) have argued,and as we shall see in Chapter 7,there are
a number of different measures of dollarisation.
16 This section draws on Hallwood and MacDonald (2000).
17 Bilateral trade intensity can be measured as either total bilateral trade divided by the
sum of total world trade of the bilateral partners,or divided by the sum of the partners
GDPs (Frankel and Rose 1998).
18 Business cycle correlation can be measured as the correlation between country pairs of
residuals from various detrending methods – as in Frankel and Rose (1998). An alternative
method of measuring the degree of macroeconomic correlation between pairs of
countries is that of Blanchard and Quah (1989). In a vector autoregression of real GDP
and inflation rates they use identifying restrictions in a way such that temporary and
permanent shocks can be identified and the correlation between countries calculated.
Bayoumi and Eichengreen (1992) were among the first to apply this methodology to
judge whether sets of countries were suitable for monetary union.
19 But not the capital account as financial integration may work in the opposite direction
(see below).
20 Using instrumental variables,where the instruments for trade intensity are chosen
from the gravity trade model (distance between countries,and dummies for adjacency
and common language) they find in an illustrative regression that an increase in trade
intensity by one standard deviation from the mean of the data increases the bilateral
correlation of business cycles from about 0.22 to 0.35.
21 Relatedly,Kalemli-Ozcan et al. (2001) find empirical support for the hypothesis
that national and regional specialisation increases as,respectively,international and
inter-regional capital market integration increases.
22 Hughes-Hallett and Piscitelli (2002) derive sets of conditions where joining a currency
union positively affects business cycle correlation between the members. In the context
of the UK,the significant theoretical result is that following the creation of a monetary
union,correlation will increase when the home economy (say,Scotland) is small in relation
to the other members (in the rest of the UK) and is not subjected to large cyclical
disturbances.
2 Purchasing power parityand the PPP puzzle
1 This chapter,and the next,draw on MacDonald (1995a).
2 The relatively slow mean reversion of the real exchange rate may be explicable
in the context of a real model where real shocks are predominant. However,real
shocks are not well suited to explaining the volatility of the real exchange rate (see
Chapter 8).
3 Such costs are usually defined broadly to include both direct transportation costs and
indirect costs such as opportunity cost.