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250 CHAPTER 8. THE MUNDELL-FLEMING MODELest rates are in logarithms. Let y t be US industrial production, p t be theUS consumer price index, nbr t be the log of non-borrowed bank reservesdivided by the log of total bank reserves, i t − i ∗ t be the 3 month USforeignnominal interest rate differential, q t be the real exchange rate,and s t be the nominal exchange rate. 11 For each US—foreign countrypair, two separate VARs were run–one using the real exchange rateand one with the nominal exchange rate. In the Þrst system, the VARis estimated for the 5-dimensional vector x t =(y t ,p t ,nbr t ,i t − i ∗ t ,q t ) 0 .In the second system, we used x t =(y t ,p t ,nbr t ,i t − i ∗ t ,s t ) 0 . 12The Þrst row of plots in Figure 8.8 shows the impulse response ofthe log real exchange rate for the US-UK, US-Germany, and US-Japan,following a one-standard deviation shock to nbr t . An increase in nbr tcorresponds to a positive monetary shock. The second row shows theresponses of the log nominal exchange rate with the same countries toa one-standard deviation shock to nbr t .Both the real and nominal exchange rates are found to depreciateupon impact but the maximal nominal depreciation occurs somemonths after the initial shock. The impulse response of both exchangerates is hump-shaped. There is evidently evidence of overshooting, butit is different from Dornbusch overshooting which is instantaneous. Thisunrestricted VAR response pattern has come to be known as delayedovershooting.Long-horizon (36 months ahead) forecast-error variance decompositionsof nominal exchange rates attributable to orthogonalized monetaryshocks are 16 percent for the UK, 24 percent for Germany, and10 percent for Japan. For real exchange rates, the percent of varianceattributable to monetary shocks is 23 percent for the UK and Germany,and 9 percent for Japan. Evidently, nominal shocks are prettyimportant in driving the dynamics of the real exchange rate.11 Interest rates for the US and UK are the secondary market 3-month TreasuryBill rate. For Germany, I used the interbank deposit rate. For Japan, the interestrate is the Japanese lending rate from the beginning of the sample to 1981.8, andis the private bill rate from 1981.9 to 1998.112 Using BIC (Chapter 2, equation 2.3) with the updated data indicated that theVARs required 3 lags. To conform with Eichenbaum and Evans, I included 6 lagsand a linear trend.
8.4. VAR ANALYSIS OF MUNDELL—FLEMING 2510.0160.0160.0140.0140.0140.0120.0120.010.010.0080.0080.0060.0060.0040.0040.0020.00200-0.0021 9 17 25 33 411 9 17 25 33 41 -0.0040.0120.010.0080.0060.0040.0020-0.002 1 9 17 25 33 41-0.004-0.0060.0120.010.0080.0060.0040.00202 10 18 26 34 420.0160.0140.0140.0120.0120.010.010.0080.0080.0060.0060.0040.0040.0020.00201 9 17 25 33 41-0.00201 9 17 25 33 41 -0.004Figure 8.8: Row 1: Impulse response of log real US-UK, US-German,US-Japan exchange rate to an orthogonalized one-standard deviationshock to nbr t . Row 2: Impulse responses of log nominal exchange rate.Clarida-Gali Structural VARIn Chapter 2.1, we discussed some potential pitfalls associated withthe unrestricted VAR methodology. The main problem is that theunrestricted VAR analyzes a reduced form of a structural model so wedo not necessarily learn anything about the effect of policy interventionson the economy. For example, when we examine impulse responsesfrom an innovation in y t , we do not know whether the underlying causewas due to a shock to aggregate demand or to aggregate supply or anexpansion of domestic credit.Blanchard and Quah [15] show how to use economic theory toplace identifying restrictions on the VAR, resulting in so-called struc-
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CONTENTSvii11 Balance of Payments C
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2 CHAPTER 1. SOME INSTITUTIONAL BAC
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104 CHAPTER 3. THE MONETARY MODELwh
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106 CHAPTER 4. THE LUCAS MODEL(76)
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108 CHAPTER 4. THE LUCAS MODELsubje
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110 CHAPTER 4. THE LUCAS MODELeach
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124 CHAPTER 4. THE LUCAS MODELTable
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126 CHAPTER 4. THE LUCAS MODEL4.5 C
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128 CHAPTER 4. THE LUCAS MODELTable
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130 CHAPTER 4. THE LUCAS MODELdisco
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132 CHAPTER 4. THE LUCAS MODEL1.02A
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134 CHAPTER 4. THE LUCAS MODELAppen
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136 CHAPTER 4. THE LUCAS MODELProbl
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138 CHAPTER 5. INTERNATIONAL REAL B
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162CHAPTER 6. FOREIGN EXCHANGE MARK
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300CHAPTER 9. THE NEW INTERNATIONAL
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308 CHAPTER 10. TARGET-ZONE MODELSa
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314 CHAPTER 10. TARGET-ZONE MODELSl
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318 CHAPTER 10. TARGET-ZONE MODELSa
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324 CHAPTER 10. TARGET-ZONE MODELS
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326 CHAPTER 10. TARGET-ZONE MODELS
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328 CHAPTER 11. BALANCE OF PAYMENTS
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358 AUTHOR INDEXFama, E.F., 161, 16
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Subject IndexAAbsorption, 16, 230AI
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362 SUBJECT INDEXEfficient capital
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364 SUBJECT INDEXMethod of undeterm
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366 SUBJECT INDEXRisk neutrality, 9
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368 SUBJECT INDEXImpulse response a
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