Abstract
During the last two decades, many exchange rates have shown large fluctuations. These fluctuations relate to both intraday changes and movements during longer periods: months and years. Concurrently, as has been illustrated in Section 1.1, the link slackened between the exchange rate and the exchange market on one hand and real phenomena such as international trade in goods and services and relative prices on the other. The figures presented in Section 1.1 show that the bulk of the transaction on the foreign exchange market is driven by financial motives.
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References
This definition of perfect capital mobility corresponds with the one presented in Dornbusch and Krugman (1976), p. 554. Some authors understand by perfect capital mobility both continuous equilibrium and perfect substitutability between domestic and foreign bonds (see e.g. De Haan et al., 1979, p. 331 and MacDonald, 1988, pp. 33 and 34).
Obstfeld and Stockman (1985, esp. pp. 954–957) show that when the menu of assets is expanded, the current account, per se, may play no role in exchange rate dynamics.
These models are unstable, see for instance Ethier (1979), Gray and Turnovsky (1979) and Kouri (1976). The instability problem can be solved by introducing a so-called transversality condition. An economic interpretation of this condition can be found in Kouri (1976).
The number of publications containing tests on the existence of a risk premium in the foreign exchange market is enormous. Surveys can be found in Levich (1985) and Hodrick (1987).
Note that some authors refer to these single equation models as “structural models”. With this term they want to differentiate these models from the pure time series models which explain the exchange rate’s current value only from past observations of its own time series. From an econometric point of view the term “structural models” is deceptive, because these equations are not the model’s structural form.
See also Keller (1980), p. 89, and Meese and Rogoff (1985). The last two authors write that to “adequately capture the effects of government deficits, it would be necessary to estimate a fully dynamic model of private saving and portfolio behaviour” (Meese and Rogoff, 1985, p. 14).
Once the parameters of the structural form are obtained, the usefulness of semi-reduced forms lies in the explanatory contribution and simplifications by means of reducing the system to a more controllable system such as a partial equilibriumM (Keller, 1984, p. 110).
It should be noted that these experiments are complicated by the fact that the disturbance terms are in general contemporaneously correlated. So to simulate a typical shock to a given variable it is necessary to recognize that the expectation of other disturbances in the system, conditional on the particular shock of interest, is usually non-zero. The solution to this problem is to specify a variable ordering. This ordering specifies that the first variable is predetermined with respect to the other variables, that the second variable is predetermined with respect to all but the first etc. Since the ordering is not unique, Meese and Rogoff use two ordering schemes. For more details, see Meese and Rogoff (1983b) and Sims (1980).
Kiviet (1985) presents sequences of tests to solve empirically the problem of both finding an adequate specification of the structural form and composing a set of admissible instrumental variables. In Section 4.3.2 we review various procedures for selecting instrumental variables and justify our selection procedure.
Studies in which the magnitude of the parameters of foreign and domestic variables are assumed to be equal are e.g. Driskill (1981a and 1981b). Driskill and Sheffrin (1981), Frankel (1979b), Hooper and Morton (1982) and Woo (1985).
If the direct correlation is perfect and the variances are equal then the weights are undefined because the denominator equals zero. Similar problems arise if the two variables are aggregated and their correlation is negative. See Haynes and Stone (1982) for more details.
Besides Haynes and Stone (1981 and 1982), Clements and Frenkel (1981) also test for this constraint.
See e.g. Johnston, 1972, p. 165. Other methods for handling the consequence of multicollinearity can be found in textbooks on econometrics (e.g. Johnston, 1972, and Judge et al., 1980).
For more details see Isard (1983), pp. 15–18 and the literature cited therein. See also De Grauwe (1988), p. 12.
See Hacche and Townend (1983) pp. 138, 139 and Woo (1985), pp. 2 and 3 and the literature cited in these publications.
Meese and Rogoff ascribe this good performance of the monetary approach model to the particular sample period and exchange rate used by Woo. See Meese and Rogoff (1985), p. 5, note 6.
A review of studies with regard to the validity of the purchasing power parity can be found in Officer (1976), MacDonald (1988), pp. 214–218 and Visser (1989), pp. 38 and 39. See also the papers in the May 1978 issue of the Journal of International Economics.
See Frankel (1981), p. 1079.
Lafrance and Racette carried out some tests for structural stability. These tests indicate that they cannot reject stability of their preferred equation. See Lafrance and Racette, 1985, pp. 246, 247.
Baillie and Selover (1987), however, find that even if the time series are appropriately differentiated the estimated coefficients do not support the monetary model or the purchasing power parity.
See e.g. Frankel and Froot (1985) and Dominguez (1986).
Hacche and Townend are of the opinion that in the case of exchange rates, the inadequate treatment of expectations in empirical estimation has been at least as responsible for the model’s failure as the possible instability of the underlying economic structure. See Hacche and Townend (1983), p. 158.
This procedure for approximating wealth and asset variables has been used in e.g. Bisignano and Hoover (1982), Branson et al. (1977), Frankel (1982a and 1982b) and Murphy and Van Duyne (1980). The detailed description of the data in Appendix 4 to Frankel (1982b) clearly illustrates the difficulties in deriving the stocks.
For example at the end of 1980 nearly 75 percent of Germany’s private claims on foreigners were denominated in marks, while nearly 40 percent of its liabilities to foreigners were denominated in currencies other than marks. See Hooper et al. (1983), p. 43.
Two methods, that account for third-country effects can be distinguished. In the first procedure the foreign variables do not refer to one single country but are weighted averages of several countries’ variables. This method is used in e.g. Fukao (1983) and Hooper (1983). The exchange rate variable can be a bilateral rate, Fukao, or an effective exchange rate, Hooper. The second method for accounting for third-country effects consists of the estimation of a multilateral exchange rate model. Good examples are the OECD and EPA models. The mechanism of exchange rate determination in these models is briefly described in Amano (1986).
As far as we know only Lorenzo Bini Smaghi and Daniel Gros add the dollar price of gold to the explaining variables of the mark-dollar rate. The study by Bini Smaghi and Gros is referred to in Frankel (1981), pp. 1080, 1081.
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© 1991 Springer-Verlag Berlin Heidelberg
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de Jong, E. (1991). Exchange Rate Determination: Theory and Empirical Tests. In: Exchange Rate Determination and Optimal Economic Policy Under Various Exchange Rate Regimes. Lecture Notes in Economics and Mathematical Systems, vol 359. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-51668-9_2
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