Exchange Rate Economics: Theories and Evidence

402 Notes
15 This result is familiar in closed economy models where the existence of an outside asset,
which is regarded as wealth by the private sector,will result in non-homogeneity between
money and prices n the long run.
16 We noted in Chapter 6 that researchers who have correctly identified the dynamic processes
in the simple monetary model have been successful in beating a random walk in
an out-of-sample forecasting context.
8 Real exchange rate determination: theoryand evidence
1 Additionally,the β term contains income,or expenditure,elasticities. It is relatively
straightforward to unravel β in terms of the underlying income,or expenditure,and
price elasticities. This is not done here because it would not affect our analysis in any
significant way; see Mussa (1984) for a further discussion.
2 Note that (8.10) is perfectly consistent with the condition of risk-adjusted uncovered
interest rate parity given in (8.5). Thus it is straightforward to rewrite (8.5) in real terms,
as we discuss later,where we have a relationship between the expected change in the
real exchange rate,real interest rates and a risk premium. The risk premium in (8.5)
exists because foreign assets are imperfect subsititutes for domestic (non-money) assets.
This is captured in (8.10) by the term µ(Â − A).
3 More specifically: η = (1/2) ·{r ∗ + (β/α) +[r ∗ + (β/α) 2 + 4 · (µβ/α)] −1/2 } >
(r ∗ + (β/α)).
4 Coughlin and Koedjik (1990) find some evidence for cointegration for one of the
currencies in their data set,namley the German mark–US dollar.
5 Throop (1994),using an error correction relationship for the real exchange rate/real
interest rate relationship reports some evidence for cointegration on the basis of the
estimated t-ratio on the error correction term; however,this is not significant on the
basis of a small sample correction.
6 Our discussion here is based on Stockman (1995).
7 As in Rogers (1999) and Weber (1998),MacDonald (1999b) advocates a wider range of
shocks (both demand and supply shocks) and also a completely different way of estimating
the effects of the shocks. In particular,MacDonald points out that in systems which
are relatively rich in terms of the numbers of shocks the cointegratedness of the system
must be recognised. The existence of significant cointegrating vectors is then used
to impose a set of long-run restrictions. The impulse response functions and variance
decompositions are then calculated using the generalised impulse response approach of
Pesaran. This approach appears to give a more balanced approach.
9 Equilibrium exchange rates: measurement and misalignment
1 The balance of payments is given by the sum of the current,ca,and capital accounts,
cap,which with flexible exchange rates must sum to zero. The current balance may be
written as: ca t = α 1 (s t −p t +pt ∗)+α 2y t −α 3 yt ∗ +i′ t nfa t ,where the first three terms reflect
the influence of the real exchange rate and home and foreign income on net exports
and the last term is net interest payments on net foreign assets. The capital account is
assumed to be a function of net interest yields adjusted for the expected change in the
exchange rate – cap t = µ(i t − it ∗ − E t s t+k ). Using these expressions for the current
and capital accounts and solving for the real exchange rate we obtain expression (9.1).
10 The new open economymacroeconomics and exchange
rate behaviour
1 If,for example,θ < 1 then as Helpman and Krugman (1985) note marginal revenue
would be negative,which is inconsistent with the assumption of monopolistic
consumption.