Exchange Rate Economics: Theories and Evidence

Notes 401
3 These results are from MacDonald and Taylor (1993).
4 Relative prices appear here since this approach allows for deviations from PPP.
5 Note that this relationship has the constraint that money enters in real terms imposed,
a constraint which is not rejected for this data set.
6 Notice that in these sub systems the Fisher conditions are not ‘pure’ Fisher conditions in
the sense that the coefficient on the interest rate term is not minus unity. However,in
the gross,or overall,system these coefficients can be restricted to minus one.
7 The dynamic one-step-ahead out-of-sample forecasts for each of the equations in the
La Cour and MacDonald system performed impressively since only 5 (out of 168) of the
forecasted values lie outside the 95% confidence intervals (none lay outside the bands
in the exchange rate equation) and the directional ability of the forecasts also proved
to be extremely good. The formal one-step-ahead restrictions test for the restricted
VECM model (which takes account of the variance of the estimated parameters and
their correlation) had a p-value of approximately 0.5.
8 Alternatively,we could work with a vector error correction model consisting of the vector
[x t , s t , ζ t ] ′ ,but information contained in this vector is preserved in a bivariate
VAR of [x t , ζ t ] ′ or [s t , ζ t ] ′ .
9 Flood and Rose (1999) conduct a similar exercise using the change in the exchange rate
and the composite monetary variable as the key variables.
7 Currencysubstitution models and the portfolio balance
approach to the exchange rate
1 Girton and Roper (1981),were the first to introduce the term currency substitution.
2 Such currencies are assumed to be non-interest-bearing.
3 In practice agents will hold a portfolio of money and non-money assets. We
shall leave inclusion of the latter in a theory of exchange rate determination until
Chapter 8.
4 For example,Laney et al. (1984),argue that in 1981 US foreign currency holdings
amounted to US$3 billion,whereas total narrowly defined money amounted to
over US$400 billion. For a further discussion of the empirical evidence on CS see
Chapter 9.
5 McKinnon (1982,p. 327).
6 Underlying the assumption that ṁ e is equal to ṡ e is a further assumption that expected
income growth is equal to zero. This type of assumption has been termed monetary
super-neutrality by Artis and Currie (1981).
7 Equation (7.14) is a condition for asset market equilibrium because via the wealth
identity,(7.12),only one of equations (7.13) and (7.13 ′ ) can be independent.
8 Kouri (1976),considers other shocks,such as a tax-financed increase in government
expenditure and the dynamics of adjustment from short-run equilibrium to the steady
state under expectational schemes.
9 A once-and-for-all increase in the price level,unaccompanied by a monetary expansion,
results in a proportionate increase in the exchange rate and price level.
10 The empirical relevance of the CS concept will be discussed in Section 7.5.
11 Strictly speaking the asset demand equations (7.38) to (7.40),should be real demands and
equation (7.37) should be real wealth,but the assumed homogeneity of asset demands
to wealth ensures that the price deflator drops out.
12 For simplicity we assume that the government taxes all domestic residents’ interest
earnings on domestic bonds.
13 Notice that this definition of the price level differs from that used in the MF model since
the exchange rate enters directly. This assumption has important implications for the
results in this chapter.
14 Examples of portfolio balance models in which expectations are assumed rational are
Dornbusch and Fischer (1980); Branson (1983) and Branson and Buiter (1983).