Modeling exchange rate dynamics in Peru: A cointegration approach using the UIP and PPP

Jaramillo Franco, Miguel and Serván Lozano, Sergio (2012): Modeling exchange rate dynamics in Peru: A cointegration approach using the UIP and PPP. Published in: Superintendence of Banks, Insurance Companies and Private Pension Funds of Peru No. DT/01/2012

Abstract

This paper investigates whether the Purchasing Power Parity (PPP) and the Uncovered Interest Rate Parity (UIP) hold for the Peruvian economy. We analyze Peruvian, international and trade-weighted foreign data for the period 1997 - 2011 using Johansen's cointegration approach. The results of our analysis suggest the existence of two stationary relations obtained after imposing overidentifying restrictions, which represent a combination of the UIP with the PPP and an equation for an augmented risk premium. In terms of monetary policy, our findings provide evidence that the aim of the Central Bank's intervention in the currency market is to smooth short-run volatility of the exchange rate, but does not have a long-run effect. After a successful identification of the stationary relations, we develop a permanent-transitory analysis following Gonzalo & Ng (2001) in order to analyze the impact of structural shocks to the error correction model variables and some relations of interest.

• Item Type: MPRA Paper
• Language: English
• Keywords: PPP, UIP, cointegration, Johansen, exchange rate, impulse responses, permanent and transitory shocks.
• 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 > C5 - Econometric Modeling > C52 - Model Evaluation, Validation, and Selection; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E43 - Interest Rates: Determination, Term Structure, and Effects; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; F - International Economics > F3 - International Finance > F30 - General; F - International Economics > F3 - International Finance > F31 - Foreign Exchange; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics

References

Abuaf, N. & Jorion, R. (1990). Purchasing Power Parity in the Long Run. The Journal of Finance 45, 157-174.

Adler, M., & Lehmann, B. (1983). Deviations from purchasing power parity in the long run. Journal of Finance, 38, 1471-1487.

Ardeni, RG. & Lubian, D. (1983). Is There a Trend Reversion in Purchasing Power Parity? European Economic Review 35, 1035-1055.

Arena, M. & Tuesta, P. (1998). Fundamentos y desalineamientos del tipo de cambio real de equilibrio en el Peru. Banco Central de Reserva el Peru, Estudios Economicos, 3, 29 - 50.

Backus, D., Gavazzoni, F., Telmer, C. & Zin, S. (2010). Monetary Policy and the Uncovered Interest Parity Puzzle. Working Paper 16218. NBER Working Paper Series.

Bevilacqua, F. (2006). Random Walks and Cointegration Relationships in International Parity Conditions between Germany and the USA for the Post Bretton Woods Period. UNU-MERIT Working Paper, ISSN 1871-9872.

Bjornland, H.C., & Hunges, H. (2002). Fundamental Determinants of the Long Run Real Exchange Rate: The Case of Norway. Discussion Paper 326, Statistics Norway.

Camarero, M., & Tamarit, C. (1993). Economic integration and the PPP-UIP hypotheses: an application to the Spanish integration in the EC. Discussion paper, Department of Economics, University Jaume I, Madrid.

Campbell, R., Koedijk, K., Lothian, J. & Mahieu, R. (2008). The Performance of UIP and PPP: Emerging Markets. City University of London (Cass).

Caporale, G. M., Kalyvitis, S. & Pittis, N. (2001). Testing for PPP and UIP in a FIML framework: some evidence for Germany and Japan. Journal of Policy Modeling 23, 637-650.

Choy, W. (2000). Were the East Asian currencies overvalued according to purchasing power parity and uncovered interest rate parity?: A cointegration approach. mimeo, New Zealand Treasury.

Cumby, R.E. & Obstfeld, M. (1981). A Note on Exchange-Rate Expectations and Nominal Interest Differentials: A Test of the Fisher Hypothesis. The Journal of Finance 36, 697-703.

Davidson, J. E. H. (1985). Econometric modeling of the Sterling effective exchange rate. Review of Economic Studies, 52, 231-250.

Diebold, F. X., Husted, S. & Rush, M. (1991). Real exchange rates under the gold standard. Journal of Political Economy, 99, 1252- 1271.

Dornbusch, R. (1976). Expectations and exchange rate dynamics. Journal of Political Economy, 84, 1161 - 1176.

Duncan, R. (2000). Examinando la condicion de paridad de tasas de interes en una economia dolarizada. Concurso de Jovenes Economistas. Banco Central de Reserva del Peru.

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

Ferreyra, J. & Herrada, R. (2003). Tipo de cambio real y sus fundamentos: Estimacion del desalineamiento. Banco Central de Reserva del Peru. Documento de Trabajo 07.

Ferreyra, J. & Salas, J. (2006). Tipo de Cambio Real de Equilibrio en el Peru: modelos BEER y construccion de bandas de confianza. Banco Central de Reserva del Peru. Documento de Trabajo 006.

Fisher, E. & Park, J. Y. (1991). Testing purchasing power parity under the null hypothesis of cointegration. Economic Journal, 101, 1476-1484.

Frenkel, J.A. (1981). The Collapse of Purchasing Power Parities during the 1970's. European Economic Review 16, 145-165.

Frydman, R. & Goldberg, M. (2001). Macroeconomic fundamentals and the DM/USD exchange rate: Temporal instability and the monetary model. International Journal of Finance and Economics, 6(4), 421 - 435.

Gokcan, A. & Ozmen, E. (2002). Do PPP and UIP need each other in a financially open economy?The Turkish evidence. No 101, ERC Working Papers from ERC - Economic Research Center, Middle East Technical University.

Gonzalo, J. (1994). Five alternative methods of estimating long-run equilibrium relationships. Journal of Econometrics, 60, 2013 - 33.

Gonzalo, J. & Ng, S. (2001). A systematic framework for analyzing the dynamic effects of permanent and transitory shocks. Journal of Economic Dynamics and Control 25, 1527 - 1546.

Hakkio, C.S. (1984). A Re-examination of Purchasing Power Parity. A Multi-Country and Multi-Period Study. Journal of International Economics 17, 265-277.

Harris , R.I.D., & Judge, G. (1998). Small sample testing for cointegration using the bootstrap approach. Economics Letters 58, 3137.

Helg, R. & Serati, M. (1996). Does the PPP Need the UIP? Liuc Papers No. 30, Serie Economia e Impresa, Maggio.

Huizinga, J. (1987). An empirical investigation of the long-run behaviour of real exchange rates. Carnegie Rochester Conference Series on Public Policy, 27, 149-214.

Humala, A. (2006). Expectativas de depreciacion y diferencial de tasas de interes: Hay regimenes cambiantes? El caso de Peru. DT. N. 2006-002. Serie de Documentos de Trabajo, Banco Central de Reserva del Peru.

Hunter, J. (1992). Tests of Cointegrating Exogeneity for PPP and Uncovered Interest Rate Parity for the UK. Journal of Policy Modeling, Special Issue: Cointegration, Exogeneity and Policy Analysis, 14 (4), pp. 453-463.

Johansen, S. (1988). Statistical analysis of cointegrating vectors. Journal of Economic Dynamics and Control, Vol. 12, pp. 231-254.

Johansen, S. (1991). Estimation and hypothesis testing of cointegration vectors in Gaussian vector autoregressive models. Econometrica, 59, pp. 1151 - 1580.

Johansen, S. & Juselius, K. (1990). Maximum likelihood estimation and inference on cointegration with application to the demand of money. Oxford Bulletin of Economics and Statistics, 52(2), 169210.

Johansen, S. & Juselius, K. (1992). Testing structural hypothesis in a multivariate cointegration analysis of the PPP and the UIP for UK. Journal of Econometrics 53, 211-244.

Jore, A.S., Skjerpen, T. & Swensen, A.R. (1992). Testing for purchasing power parity and interest rate parities on Norwegian data, D.P. no. 101. Norway: Central Bureau of Statistics.

Juselius, K. (1995). Do purchasing power parity and uncovered interest rate parity hold in the long run? An example of likelihood inference in a multivariate time series model. Journal of Econometrics 69, 211-240.

Juselius, K. (2006). The Cointegrated VAR Model: Methodology and Applications. Oxford University Press.

Juselius, K. & MacDonald, R. (2000). International parity relationships between Germany and the United States, Unpublished report, European University Institute.

Kim, Y. (1990). Purchasing Power Parity in the Long Run: A Cointegration Approach. Journal of Money, Credit and Banking 22, 491-503.

Kugler, P. & Lenz, C. (1993). Multivariate cointegration analysis and the long-run validity of PPP. Review of Economics and Statistics, 75, 180-187.

Lothian, J. & Taylor M.P. (1996). Real exchange rate behavior: The recent float from the perspective of the past two centuries, Journal of Political Economy, Vol.104, No.3, pp. 488-509.

MacDonald, R. (1985). Do deviations of the real effective exchange rate follow a random walk? Economic Notes, 14 (1), 63- 69.

MacDonald, R. (1993). Long-run purchasing power parity: is it for real? Review of Economics and Statistics, 75 (4), 690- 695.

MacDonald, R. (1999). Exchange rate behavior: Are fundamentals important? The Economic Journal, 109, F673-F691.

MacDonald, R. (2000). Concepts to Calculate Equilibrium Exchange Rates: An Overview. DP 03, Economic Research Group, Deutsche Bundesbank.

MacDonald, R. & Marsh, I. W. (1994). On long and short-run purchasing power parity. In: J. Kaehler, & P. Kugler (Eds.), Econometric analysis of financial markets, 23-46. Heidelberg, Germany: Physica-Verlag.

MacDonald, R. & Marsh, I. W. (1997). On fundamentals and exchange rates: A Casselian perspective. Review of Economics and Statistics, 78, 655-664.

MacDonald, R. & Marsh, I. W. (1999). Exchange Rate Modelling. Kluwer Academic Publishers: Dordrecht.

MacDonald, R. & Moore, M. J. (1994). Long-run purchasing power and structural change, W.P. A/F 94-2. Belfast: The Queen's University of Belfast.

McCallum, B. T. (1992). A Reconsideration of the Uncovered Interest Parity Relationship. WP 4113.NBER Working Paper Series.

McNown, R. & Wallace, M.S. (1990). Cointegration Tests of Purchasing Power Parity Among Four Industrial Countries: Results for Fixed and Flexible Rates. Applied Economics 22, 1729-1737.

Melander, O. (2009). Uncovered Interest Parity in a Partially Dollarized Developing Country: Does UIP Hold in Bolivia? (And If Not, Why Not?). SSE/EFI Working Paper Series in Economics and Finance No. 716.

Meredith, G. & Chinn, M.D. (1998). Long-Horizon Uncovered Interest Rate Parity. NBERWorking Paper 6797 (November).

Ng, S. & Perron, P. (2002). PPP May not Hold After all: A Further Investigation. CEMA Working Papers 83, China Economics and Management Academy, Central University of Finance and Economics.

Obstfeld, M. & Rogoff, K. (2000). The six major puzzles in international macroeconomics: Is there a common cause? NBER Working Paper Series No. 7777.

Pesaran, M.H., Shin, Y. & Smith, R. (2000). Structural Analysis of Vector Error Correction Models with Exogenous I(1) Variables. Journal of Econometrics, 5, pp. 256-271.

Rashid, A. & Abbas, K. (2008). An Empirical Analysis of the Combined PPP and UIP: Evidence from South Asia. South Asia Network of Economic Research Institutes.

Rodriguez, D. & Winkelried, D. (2011). Que explica la evolucion del tipo de cambio real de equilibrio en el Peru? . Revista Moneda N 147. Banco Central de Reserva del Peru.

Rogoff, K. (1996). The Purchasing Power Parity Puzzle. Journal of Economic Literature, Vol. 34, No. 2., pp. 647-668.

Roll, R. (1979). Violations of purchasing power parity and their implications for efficient international commodity markets. In: M. Sarnat, & G. Szego (Eds.), International finance and trade. Cambridge, MA: Ballinger.

Sarno, L.& Taylor M. (1998). The behavior of real exchange rates during the post-Bretton Woods period, Journal of International Economics, 46, 281-312

Sarno, L. & Taylor, M. (2002). The Economics of Exchange Rates. Cambridge University Press.

Sjoo, B. (1995). Foreign transmission effects in Sweden: do PPP and UIP hold in the long run? Advances in International Banking and Finance, 1, 129- 149.

Stephens, D. (2004). The equilibrium exchange rate according to PPP and UIP. Reserve Bank of New Zealand, DP2004/03.

Taylor, M. P. (1987). Risk premia and foreign exchange: a multiple time series approach to testing uncovered interest parity. Weltwirtschaftliches Archiv, 123 (4), 579- 591.

Taylor, M. P. (1988). An empirical examination of long-run purchasing power parity using cointegration techniques. Applied Economics, 20, 1369-1382.

Taylor, M.R (1992). Dollar-Sterling Exchange Rate in the 1920's. Purchasing Power Parity and the Norman Conquest of $4.86. Applied Economics 24, 803-811.

Taylor, A. (2001). Potential pitfalls for the purchasing-power-parity puzzle: Sampling and specification biases in mean-reversion tests of the law of one price, Econometrica, 69(2), 473-98.

Trozano, M. (1992). Long-run Purchasing Power Parity and Mean-Reversion in Real Exchange Rates: A Further Assessment. Economia Internazionale 45, 77-100.

Whitt, J. A. (1992). The long-run behaviour of the real exchange rate: a reconsideration. Journal of Money, Credit and Banking, 24 (1), 72- 82.