Commonality and Heterogeneity in Real Effective Exchange Rates: Evidence from Advanced and Developing Countries

Nagayasu, Jun (2016): Commonality and Heterogeneity in Real Effective Exchange Rates: Evidence from Advanced and Developing Countries.

Abstract

In order to differentiate between commonality and heterogeneity in real effective exchange rates, which are considered a measure of external competitiveness, we decompose their movements into global and country-specific factors using the Bayesian factor model. First, we show a complex but often positive relationship between real exchange rates and net trade volume using panel data of developed and developing countries. Then we report a particular global trend in real exchange rates, but a substantial proportion of their variation is found to be country-specific. In line with this finding, we conclude that structural shifts, when they do exist, are considered country-specific factors. Furthermore, consistent with economic theory, this global factor is closely related to a trend in the global interest rate, while country-specific factors are closely related to idiosyncratic movements in the countries' own interest rates. Such a decomposition results in better model performance in terms of coefficient signs, and therefore our results suggest that external competitiveness is heterogeneous among countries and that economic policy can influence countries’ competitiveness.

• Item Type: MPRA Paper
• Language: English
• Keywords: Real effective exchange rates; factor model; variance decomposition; external competitiveness
• Subjects: F - International Economics > F3 - International Finance

References

Alessi, L., M. Barigozzi and M. Capasso (2010). Improved penalization for determining the number of factors in approximate factor models. Statistics and Probability Letters 80, 1806-1813.

Andrews, D. W. K. (1993). Tests for parameter instability and structural change with unknown change point. Econometrica 61 (4), 821–856.

Andrews, D. W. K. and W. Ploberger (1994). Optimal tests when a nuisance parameter is present only under the alternative, Econometrica 62(6), 1383-1414.

Bai, J. and S. Ng (2002). Determining the number of factors in approximate factor models. Econometrica 70, 191-221.

Barkoulas, John T., Christopher F. Baum, and Mustafa Caglayan (2002). Exchange rate effects on the volume and variability of trade flows, Journal of International Money and Finance 21, 481-496.

Bayoumi, T., G. Fazio, M. Kumar, and R. MacDonald (2007). Fatal attraction: Using distance to measure contagion in good times as well as bad. Review of Financial Economics 16 (3), 259 – 273.

Bernanke, B., J. Boivin, and P. S. Eliasz (2005). Measuring the effects of monetary policy: A factor-augmented vector autoregressive (FAVAR) approach. The Quarterly Journal of Economics 120 (1), 387–422.

Bhalla, S. S. (2008). Economic development and the role of currency undervaluation. Cato Journal 28, 313–340.

Brixiova, Z., B. Egert, and T. H. A. Essid (2013). The real exchange rate and external com- petitiveness in Egypt, Morocco and Tunisia. African Development Bank Group Working Paper 187.

Byrne, J. P. and J. Nagayasu (2010). Structural breaks in the real exchange rate and real interest rate relationship. Global Finance Journal 21 (2), 138–151.

Canova, F. and M. Ciccarelli (2009). Estimating multicountry VAR models. International Economic Review 50 (3), 929–959.

Cayen, J.-P., D. Coletti, R. Lalonde, and P. Maier (2010). What drives exchange rates? new evidence from a panel of U.S. dollar bilateral exchange rates. Technical report, Bank of Canada Working Paper 2010-5.

Chinn, M. D. and J. A. Frankel (1995). Who drives real interest rates around the Pacific Rim: the USA or Japan? Journal of International Money and Finance 14(6), 801-821.

Choi, I. (2001). Unit root tests for panel data. Journal of International Money and Finance 20, 249–272.

Cumby, R. E. and F. S. Mishkin (1986). The international linkage of real interest rates: the European-US connection. Journal of International Money and Finance 5(1), 5-23.

Dungey, M. (1999). Decomposing exchange rate volatility around the Pacific Rim. Journal of Asian Economics 10 (4), 525 – 535.

Eberhardt, M. and S. Bond, 2009, Cross-section dependence in nonstationary panel models: a novel estimator, MPRA No. 17870.

Edison, H. J. and W. R. Melick (1999). Alternative approaches to real exchange rates and real interest rates: three up and three down. International Journal of Finance & Economics 4(2), 93-111.

Edison, H. J. and B. D. Pauls (1993). A re-assessment of the relationship between real exchange rates and real interest rates: 1974–1990. Journal of Monetary Economics 31, 165–87.

Evans, Martin D.D. and Richard K. Lyons, 2002, Order flow and exchange rate dynamics, Journal of Political Economy 110, 170-180.

Fisher, R. A. (1932). Statistical Methods for Research Workers 4th ed. Edinburgh: Oliver & Boyd.

Foerster, A. T., P.-D. G. Sarte, and M. W. Watson (2011). Sectoral versus aggregate shocks: A structural factor analysis of industrial production. Journal of Political Economy 119, 1 – 38.

Forbes, K. J. and R. Rigobon (2002). No contagion, only interdependence: Measuring stock market comovements. Journal of Finance 57 (5), 2223–2261.

Forni, M., M. Hallin, M. Lippi, and L. Reichlin (2000). The generalized dynamic-factor model: Identification and estimation. The Review of Economics and Statistics 82 (4), pp. 540–554.

Frankel, J. and S.-J. Wei (2008). Estimation of de facto exchange rate regimes: Synthesis of the techniques for inferring flexibility and basket weights. IMF Staff Papers 55 (3), 384–416.

Gagnon, J. E. and M. D. Unferth (1995). Is there a world real interest rate? Journal of International Money and Finance 14(6), 845-855.

Gerlach, S. and F. Smets (1995). Contagious speculative attacks. European Journal of Political Economy 11 (1), 45–63.

Geweke, J. and G. Zhou (1996). Measuring the pricing error of the arbitrage pricing theory. Review of Financial Studies 9, 557-587.

Geweke, J. and S. Porter-Hudak (1983). The estimation and application of long memory time series models. Journal of Time Series Analysis, 221-238.

Goodwin, B. K. and T. J. Grennes (1994). Real interest rate equalization and the integration of international financial markets. Journal of International Money and Finance 13(1), 107-124.

Granger, C. W. J and R. Joyeux (1980). An introduction to long-memory time series models and fractional differencing. Journal of Time Series Analysis 1(1), 15-29.

Hallwood, C. P. and R. MacDonald, 2000, International Money and Finance, 3rd ed., Oxford: Blackwell.

Hansen, B. E. (1997). Approximate asymptotic p values for structural-change tests. Journal of Business & Economic Statistics 15(1), 60-67.

Koedijk, K. and P. Schotman (1989). Dominant real exchange rate movements. Journal of International Money and Finance 8 (4), 517 – 531.

Koop, G. (2003). Bayesian Econometrics. John Wiley & Sons. Kose, M. A., C. Otrok, and C. H. Whiteman (2003). International business cycles: World, region, and country-specific factors. American Economic Review 93 (4), 1216–1239.

Levin, A., C.-F. Lin, and C.-S. J. Chu (2002). Unit root tests in panel data: Asymptotic and finite-sample properties, Journal of Econometrics 108, 1–24.

Levy-Yeyati, Eduardo, Federico Sturzenegger, and Pablo Alfredo Guzmann, 2013, Fear of appreciation, Journal of Development Economics 101, 233-247.

Liu, Y., M.-S. Pan, and J. Shieh (1998). International transmission of stock price movements: Evidence from the U.S. and five Asian-Pacific markets. Journal of Economics and Finance 22, 59–69.

Longin, F. and B. Solnik (1995). Is the correlation in international equity returns constant: 1960-1990? Journal of International Money and Finance 14 (1), 3–26.

MacDonald, R., and J. Nagayasu (2000). The long-run relationship between real exchange rates and real interest rate differentials: a panel study. IMF Staff Papers 47(1), 116-128.

Masson, P. R. (1998). Contagion-monsoonal effects, spillovers, and jumps between multiple equilibria. IMF Working Papers 98/142, International Monetary Fund.

Mbaye, S. (2013). Currency uundervaluation and growth: is there a productivity channel? International Economics 133, 8-28.

McKinnon, R. and G. Schnabl (2003). Synchronised business cycles in East Asia and fluctuations in the yen/dollar exchange rate. The World Economy 26 (8), 1067–1088.

McKenzie, Michael D. (1999). The impact of exchange rate volatility on international trade flows, Journal of Economic Survey 13, 71-106.

Monadjemi M. (1997). International interest rates linkages: evidence from OECD countries. International Review of Financial Analysis 6(3), 229-240.

Mumtaz, H. and P. Surico (2012). Evolving international inflation dynamics: world and country- specific factors. Journal of the European Economic Association 10 (4), 716–734.

Nellis, J. G. (1982). A principal components analysis of international financial integration under fixed and floating exchange rate regimes. Applied Economics 14 (4), 339–354.

Obstfeld, M. and R. S. Kenneth (1996). Foundations of International Macroeconomics. MIT Press.

Orzaghova, Lucia, Li Savelin and Willem Schudel (2013). External competitiveness of EU candidate countries, European Central Bank Occasional Paper Series No. 141.

Pesaran, M. H. and R. Smith (1995). Estimating long-run relationships from dynamic heterogeneous panels. Journal of Econometrics 68(1), 79-113.

Phillips, P. C.B., 1999, Discrete fourier transforms of fractional processes, 1999, Working paper No. 1243, Cowles Foundation for Research in Economics, Yale University.

Reinhart, C. M. and S. Calvo (1996). Capital flows to Latin America: Is there evidence of contagion effects? In G. A. Calvo, M. Goldstein, and E. Hochreiter (Eds.), Private Capital Flows to Emerging Markets After the Mexican Crisis, Peterson Institute Press: Chapters, pp. 151–171. Peterson Institute for International Economics.

Rodrik, D. (2008). The real exchange rate and growth. Harvard University.

UNCTAD (2012). Development and globalization: facts and figures 2012. UNCTAD: Geneva.

Volosovych, V. (2013). Learning about financial market integration from principal components analysis. CESifo Economic Studies 59 (2), 360–391.