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Does the nominal exchange rate regime affect the RIP condition?

Does the nominal exchange rate regime affect the RIP condition?. Christian Dreger, DIW Berlin. Contribution of the paper. RIP combines two cornerstones in international finance: ex ante PPP and UIP Expected real returns equalised across countries Deviations indicate lack of market integration

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Does the nominal exchange rate regime affect the RIP condition?

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  1. Does the nominal exchange rate regime affect the RIP condition? Christian Dreger, DIW Berlin

  2. Contribution of the paper • RIP combines two cornerstones in international finance: ex ante PPP and UIP • Expected real returns equalised across countries • Deviations indicate lack of market integration • Previous studies refer to post Bretton Woods • Impact of nominal exchange rate regime • Real exchange rates behave like nominal rates in flexible regimes • Independent monetary policies in flexible regimes • Impact of historical episode: Capital controls and barriers to trade decreased over the past decades Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X

  3. Unit root analysis of RIP • RIP implies mean reverting of real interest rate differentials (RIDs) • Time series tests have low power against stationarity in small samples • Evidence mixed in post Bretton woods era • Longer time periods can invalidate results because of structural breaks • Solution: Panel unit root analysis • Sources of nonstationarities can be identified Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X

  4. Panel tests of PPP • Broader information set due to inclusion of cross section • Higher power of tests, lower risk of structural breaks • More insights: Impact of nominal exchange rate regime can be explored • Mussa (1986) vs Grilli & Kaminsky (1991) • Evidence might be biased due to cross section dependencies • First generation tests (Levin, Lin & Chu, 2002, IPS, 2004) • Correlation structures is embedded via common factor structure Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X

  5. Panel tests of PPP (cont‘d) • IPS (2004) test with mean adjusted data • Cross section correlation via common time effects • Pesaran (2007) test • ADF extended by cross sectional averages • Bai and Ng PANIC approach (2004) • RIDs splitted into common and idiosyncratic parts using PCA • Unit root analysis separately for each component • Common component: time series approach (ADF or Johansen) • Idiosyncratic component: first generation panel tests Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X

  6. Empirical design • 14 RIDs relative to US, 4 regimes for nominal exchange rates • Gold Standard (1870-1914), interwar float (1920-1938), Bretton Woods (1950-1972), managed float (1973-2006) • Long term nominal interest rates, CPI inflation, from Global Financial Data and Global Insight • Determination of lag structures, number of factors etc by information criteria Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X

  7. RIDs relative to US Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X

  8. RIDs relative to US (cont‘d) Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X

  9. Common component of RIDs Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X

  10. Panel unit root analysis Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X

  11. Adjustment towards RIP • Half lives lower for fixed exchange rates (EA), increase after Bretton Woods Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X

  12. Conclusions • RIP valid as a long run condition for all periods • Unit root rejected for common and idiosyncratic components • Adjustment towards RIP affected by historical episodes and nominal exchange rate regimes • Half lives lower for fixed exchange rate regime, no real interest channel available for EA members • Although markets have become more integrated, half lives are longer for the recent float • Price stickiness higher after WWII, larger weight of trade in determination of exchange rates Financial Systems, Efficiency and Stimulation of Sustainable Growth Working Paper FINESS.D.X.X

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