Exchange Rate Determination and Out of Sample Forecasting: Cointegration Analysis

Hina, Hafsa and Qayyum, Abdul (2015): Exchange Rate Determination and Out of Sample Forecasting: Cointegration Analysis.

Abstract

Forecasting the nominal exchange rate has been one of the most difficult exercises in economics. This study employs the Frankel (1979) monetary model of exchange rate to examine the long run behavior of Pakistan rupee per unit of US dollar over the period 1982:Q1 to 2012:Q2. Johansen and Juselious (1988,1992) likelihood ratio test indicates one long-run cointegrating vector among the fundamentals. Cointegrating vector is uniquely identified as Dornbusch (1976) monetary model by imposing plausible economic restrictions. Finally, the short-run dynamic error correction model is estimated on the bases of identified cointegrated vector. Out of sample forecasting analysis of parsimonious short run dynamic error correction model is able to beat the naïve random walk model on the basis of root mean square error, Theil’s U coefficient and Diebold and Mariano (1995) test statistics.

• Item Type: MPRA Paper
• Language: English
• Keywords: Exchange rate determination; Unit root; Cointegration; Error correction model; Forecasting; Random walk model
• Subjects: C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C32 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes ; State Space Models; C - Mathematical and Quantitative Methods > C4 - Econometric and Statistical Methods: Special Topics; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C58 - Financial Econometrics; F - International Economics > F3 - International Finance; F - International Economics > F3 - International Finance > F31 - Foreign Exchange

References

Abas, K. H. and Yusof, Z. (2009). Exchange Rate and Monetary Fundamentals: Evidence from Malaysia and Japan. International Conference on Business and Information (BAI2009).

Abbas, Z. Khan, S. and Rizvi, S. T. (2011). Exchange Rates and Macroeconomic Fundamentals: Linear Regression and Cointegration Analysis on Emerging Asian Economies. International Review of Business Research Papers, 7, 250-263.

Anaraki, N. K. (2007). Meese and Rogoff’s Puzzle Revisited. International Review of Business Research Papers, 3, 278- 304.

Balke, N. S. and Famby, T. B. (1994). Large Shocks, Small Shocks and Economic Fluctuations: Outliers in Macroeconomic Time Series. Journal of Applied Econometrics, 9,181-200.

Bilson, J. F. O. (l978). The Monetary Approach to the Exchange Rate: Some Empirical Evidence. IMF Staff Papers, 25, 48-75.

Cheung, Y. W., Chinn, M. D. and Pascual, A. G. (2002). Empirical Exchange Rate Models of the Nineties: Are any Fit to Survive? National Bureau of Economic Research, Working Paper 9393.

Chinn, M. and Meese, R.(1992). Banking on Currency Forecasts: How Predictable is Change in Money? University of California, Santa Cruz.

Choudhri, E. U. and Khan, M. S. (2002). The Exchange Rate and Consumer Prices in Pakistan: Is Rupee Devaluation Inflationary? The Pakistan Development Review, 41,107-120.

Craigwell, R., Wright, A. S. and Singh, D. R. (2011). Exchange Rate Determination in Jamaica: A Market Micro structures and Macroeconomic Fundamentals Approach. Journal of Business, Finance and Economics in Emerging Economies, 1, 31-61.

Diamandis, P. F. and Kouretas, G. P. (1996). Exchange Rate Determination: Empirical Evidence for the Greek Drachma. Managerial and Decision Economics, 17, 277-290.

Diamandis, P. F., Georgoutsos, D. A. and Kouretas, G. P. (1998). The Monetary Approach to exchange Rate: Long Run Relationships, Identification and Temporal Stability. Journal of Macroeconomics, 20, 741-766.

Dibooglu, S. and Enders, W. (1995). Multiple Cointegrating Vectors and Structural Economic Models: An Application to the French Franc/U. S. Dollar Exchange. Southern Economic Journal, 61, 1098-1116.

Diebold, F. X. and Mariano, R. S. (1995). Comparing predictive accuracy. Journal of Business & Economic Statistics, 13, 253-263.

Dijk, D. V., Franses, H. S. and Lucas. A. (1999). Testing for Smooth Transition Nonlinearity in the Presence of Outliers. Journal of Business & Economic Statistics, 17, 217-235.

Dornbusch, R. (1976). The Theory of Flexible Exchange Rates and Macroeconomic Policy. Scandinavian Journal of Economics, 78, 255-75.

Dornbusch, R. and Fischer, S., (1980). Exchange Rates and the Current Account. American Economic Review, 70, 960-971.

Engle, R. F. and Granger, C. W.J. (1987). Cointegration and Error Correction: Representation, Estimation, and Testing. Econometrica, 55, 251-76.

Faust, J., Rogers, J. H. and Wright, J. H. (2003). Exchange Rate Forecasting: The Errors We've Really Made. Journal of International Economics, 60, 35-59.

Fleming, J. M. (1962). Domestic Financial Policies Under Fixed and Under Floating Exchange Rates. I.N.F. Staff Papers, 9, 369-79.

Frankel, J.A. (1979). On the Mark :A Theory of Floating Exchange Rate Based on Real Interest Differentials. American Economic Review, 69, 610-22.

Frankel, J. A. (1984). Tests of Monetary and Portfolio Balance Models of Exchange Rate Determination. Chapter 7, Exchange Rate Theory and Practice, University of Chicago Press.

Frenkel, J. A. (1978. Purchasing Power Parity: Doctrinal Perspectives and Evidence from 1920s. Journal of International Economics, 8, 169-191.

Frenkel, J. A.(1976). A monetary Approach to Exchange Rate: Doctrinal Aspects and Empirical Evidence. Scandinavian Journal of Economics, 78, 200-24.

Frenkel, J. A. and Johnson, H. G. (1976). The Economics of Exchange Rate. Addison Wesley.

Gebreselasie, T. G, Akanbi, O. A. and Siche, M. (2005). Estimating an Econometric Model of the Rand-USD Nominal Exchange Rate. Department of Economics Working Paper Series, University of Pretoria.

Harris, R. and Robert, S. Harris, R. (2003). Applied Time Series Modelling and Forecasting. John Wiley and Sons, Chichester.

Hendry, D. F. (1995). Dynamic Econometrics. Oxford University Press.

Hwang, J. K. (2001). Dynamic Forecasting of Monetary Exchange Rate Models: Evidence from Cointegration. International Advances in Economics Research, 7, 51-64

Hylleburg, S., Engle, R.F., Granger, C. E. J. and Yoo, B. S. (1990). Seasonal Integration and Cointegration. Journal of Econometrics 44, 215-28.

International Monetary Fund, (2010). International financial statistics, CD-ROM, Washington, DC: International Monetary Fund.

Johansen, S. (1988). Statistical Analysis of Cointegrating Vectors. Journal of Economic Dynamic and Control, 12, 231-254.

Johansen, S. (1991). Estimating and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models. Econometrica, 59, 1551-80.

Johansen, S. (1995). Likelihood-based Inference in Cointegrated Vector Autoregressive Models. Oxford University Press.

Johansen, S. and Juselius, K. (1990).The Maximum Likelihood Estimation and Inference on Cointegration- with Application to Demand for Money. Oxford Bulletin of Economics and Statistics, 52, 169-210.

Johansen, S. and Juselius, K. (1992). Testing Structural Hypothesis in a Multivariate Cointegration Analysis of the PPP and UIP for UK. Journal of Econometrics, 53, 211-44.

Johnston, B. and Sun, Y. (1997). Some Evidence on Exchange Rate Determination in Major Industrial Countries. IMF, Monetary and Exchange Affairs Department, Working Paper 98.

Kasa, K. (1992). Common stochastic trends in international stock markets. Journal of Monetary Economics, 29, 95–124.

Kemal, A. R. and Arby, M. F. (2004). Quarterisation of Annual GDP of Pakistan. Pakistan Institute of Development Economics, Islamabad, Statistical Papers Series No. 5, December.

Kemal, M. A. and Qadir, U. (2005). Real Exchange Rate, Exports, and Imports Movements: A Trivariate Analysis. The Pakistan Development Review, 44,177-195.

Kemal, M. A. and Haider, R. M. (2004). Exchange Rate Behaviour after Recent Float: The Experience of Pakistan. The Pakistan Development Review, 43, 829-852.

Khalid. M. A. (2007). Empirical Exchange Rate Models for Developing Economies: A Study on Pakistan, China and India. Empirical Exchange Rate Models for Developing Economies, Warwick Business School.

Korap, L.(2008). Exchange Rate Determination of Tl/Us$:A Co-Integration Approach. Econometrics and Statistics, 7, 24-50.

Kouretas, G. P. and Zarangas, L. P. (1998). A Cointegration Analysis of the Official and Parallel Foreign Exchange Markets for Dollars in Greece. International Journal of Finance and Economics, 3, 261-276.

MacDonald, R. (1997). What determines real exchange rates? The long run and short of it. International Monetary Fund, Working Paper 21.

MacDonald, R. (1995). Long-Run Exchange Rate Modelling. International Monetary Fund, Staff Paper, 42, 437-489

Malik, K. S. (2011). Exchange Rate Forecasting and Model Selection in Pakistan (2000-2010). Journal of Business and Economics, 3, 77-101.

Mark, N. C. (1995). Exchange Rates and Fundamentals: Evidence on Long-Horizon Predictability. American Economic Review, 85, 201-218.

Cushman, D. O. (2007). A Portfolio Balance Approach to the Canadian–U.S. Exchange Rate. Review of Financial Economics, 16, 305-320.

Mark, N. C. and Choi. D. Y. ( 1996). Real Exchange-Rate Prediction Over Long Horizons. Department of Economics, The Ohio State University.

Morley, B. (2009). A Comparison of Two Alternative Monetary Approaches to Exchange Rate Determination over the Long-Run. International Econometric Review, 1, 63-76.

Mundell, R. A. (1962). The Appropriate Use of Monetary and Fiscal Policy for Internal and External Stability. IMF Staff Papers, 9, 70-76.

Mussa M. (1976). The Exchange Rate, the Balance of Payments, and Monetary and Fiscal Policy under a Regime of Controlled Floating. Scandinavian Journal of Economics, 78, 229-48.

Najand, M. and Bond, C. (2000). Structural Models of Exchange Rate Determination. Journal of Multinational Finance Management, 10, 15-27.

Obstfeld, M. and Taylor, A. M. (1997). Nonlinear Aspects of Goods-market Arbitrage and Adjustment: Heckscher’s Commodity Points Revisited. Journal of the Japanese and International Economies, 11, 441-479.

Oskooee, M. B. and Kara, O. (2000). Exchange rate overshooting in Turkey. Economics Letters 68, 89-93.

Pearce, D. K. (1983). Alternative views of exchange rate determination. Economic Review, 1, 16–31.

Qayyum, A. (2005). Modelling the Demand for Money in Pakistan, The Pakistan Development Review, Vol.44(3), pp. 233-252.

Rashid, A. (2006). Do Exchange Rates Follow Random Walks? An Application of Variance- Ration Test. Pakistan Economic and Social Review, Vol. 44, 57-79.

Reimers, H. E. (1992). Comparisons of Tests for Multivariate Cointegration. Statistical Papers, 33, 335-59.

Rogoff, K. (1996). The Purchasing Power Parity Puzzle. Journal of Economic Literature, 34, 647-668.

Meese, R. A. and Rogoff, K. (1983a). Empirical Exchange Rate Models of the Seventies: Do they Fit Out of Sample? Journal of International Economics, 14, 3-24.

Meese, R. A. and Rogoff, K. (1983b). The Out of Sample Failure of Empirical Exchange Rate Models: Sampling Error or Misspecification in J.A. Frenkel (ed.), Exchange rate and International Economics. Chicago: University of Chicago Press.

Saeed, A., Awan, R. U., Sial, M. H. and Sher, F. (2012). An Econometrics Analysis of determinants of Exchange Rate in Pakistan. International Journal of Business and Social Science, 3, 184-196.

Serletis, A., King, M. (1997). Common stochastic trends and convergence of European Union stock markets. The Manchester School, 65, 44-57.

State Bank of Pakistan, (Various Issues). Monthly Statistical Bulletin, Karachi.

Stock, J. H. and Watson, M. W. (2003). Introduction to Econometrics. Addison Wesley.

Taylor, M. P. (1995). The Economics of Exchange Rate. Journal of Economic Literature, 33, 17-41.

Wong, M. (2004). A Monetary Approach to the Sterling-US Dollar Exchange Rate. Middlesex University Business School.