International Macroeconomics and Finance: Theory and Empirical Methods Nelson C. Mark December 12, 2000 forthcoming, Blackwell Publishers i To Shirley, Laurie, and Lesli ii Preface This book grew out of my lecture notes for a graduate course in in- ternational macroeconomics and (cid:222)nance that I teach at the Ohio State University. The book is targeted towards second year graduate stu- dents in a Ph.D. program. The material is accessible to those who have completed core courses in statistics, econometrics, and macroeconomic theory typically taken in the (cid:222)rst year of graduate study. These days, there is a high level of interaction between empirical and theoretical research. This book re(cid:223)ects this healthy development by integrating both theoretical and empirical issues. The theory is in- troduced by developing the canonical model in a topic area and then its predictions are evaluated quantitatively. Both the calibration method and standard econometric methods are covered. In many of the empir- ical applications, I have updated the data sets from the original studies and have re-done the calculations using the Gauss programming lan- guage. The data and Gauss programs will be available for downloading from my website: www.econ.ohio-state.edu/Mark. There are several different (cid:145)camps(cid:146) in international macroeconomics and (cid:222)nance. One of the major divisions is between the use of ad hoc and optimizing models. The academic research frontier stresses the theoretical rigor and internal consistency of fully articulated general equilibrium models with optimizing agents. However, the ad hoc mod- els that predate optimizing models are still used in policy analysis and evidently still have something useful to say. The book strikes a middle ground by providing coverage of both types of models. Someoftheotherdivisionsinthe(cid:222)eldare(cid:223)exiblepriceversussticky pricemodels, rationality versusirrationality, andcalibration versus sta- tistical inference. The book gives consideration to each of these (cid:145)mini debates.(cid:146) Each approach has its good points and its bad points. Al- though many people feel (cid:222)rmly about the particular way that research in the (cid:222)eld should be done, I believe that beginning students should see a balanced treatment of the different views. Here(cid:146)s a brief outline of what is to come. Chapter 1 derives some basicrelationsandgivessomeinstitutionalbackgroundoninternational (cid:222)nancial markets, national income and balance of payments accounts, and central bank operations. iii Chapter 2 collects many of the time-series techniques that we draw upon. It is not necessary work through this chapter carefully in the (cid:222)rst reading. I would suggest that you skim the chapter and make note of the contents, then refer back to the relevant sections when the need arises. This chapter keeps the book reasonably self-contained and provides an efficient reference with uniform notation. Many different time-series techniques have been implemented in the literature and treatments of the various methods are scattered across different textbooks and journal articles. It would be really unkind to send you to multiple outside sources and require you to invest in new notation to acquire the background on these techniques. Such a strat- egy seems to me expensive in time and money. While this material is not central to international macroeconomics and (cid:222)nance, I was con- vinced not to place this stuff in an appendix by feedback from my own students. They liked having this material early on for three reasons. First, they said that people often don(cid:146)t read appendices; second, they said that they liked seeing an econometric roadmap of what was to come; and third, they said that in terms of reference, it is easier to (cid:223)ip pages towards the front of a book than it is to (cid:223)ip to the end. Moving on, Chapters 3 through 5 cover (cid:145)(cid:223)exible price(cid:146) models. We beginwiththeadhocmonetarymodelandprogresstodynamicequilib- rium models with optimizing agents. These models offer limited scope for policy interventions because they are set in a perfect world with no market imperfections and no nominal rigidities. However, they serve as a useful benchmark against which to measure re(cid:222)nements and progress. The next two chapters are devoted to understanding two anomalies in international macroeconomics and (cid:222)nance. Chapters 6 covers devia- tions from uncovered interest parity (a.k.a. the forward-premium bias), and Chapter 7 covers deviations from purchasing-power parity. Both topics have been the focus of a tremendous amount of empirical work. Chapters 8 and 9 cover (cid:145)sticky-price(cid:146) models. Again, we begin with ad hoc versions, this time the Mundell(cid:151)Fleming model, then progress to dynamic equilibrium models with optimizing agents. The models in these chapters do suggest positive roles for policy interventions be- cause they are set in imperfectly competitive environments with nomi- nal rigidities. Chapter 10 covers the analysis of exchange rates under target zones. iv We take the view that these are a class of (cid:222)xed exchange rate mod- els where the central bank is committed to keeping the exchange rate within a speci(cid:222)ed zone, although the framework is actually more gen- eral and works even when explicit targets are not announced. Chapter 11 continues in this direction by with a treatment of the causes and timing of collapsing (cid:222)xed exchange rate arrangements. The(cid:222)eldofinternationalmacroeconomicsand(cid:222)nanceisvast. Keep- ing the book sufficiently short to use in a one-quarter or one-semester course meant omitting coverage of some important topics. The book is not a literature survey and is pretty short on the history of thought in the area. Many excellent and in(cid:223)uential papers are not included in the citation list. This simply could not be avoided. As my late colleague G.S. Maddala once said to me, (cid:147)You can(cid:146)t learn anything from a fat book.(cid:148) Since I want you to learn from this book, I(cid:146)ve aimed to keep it short, concrete, and to the point. To avoid that (cid:145)black-box(cid:146) perception that beginning students some- times have, almost all of the results that I present are derived step-by- step from (cid:222)rst principles. This is annoying for a knowledgeable reader (i.e., the instructor), but hopefully it is a feature that new students will appreciate. My overall objective is to efficiently bring you up to the research frontier in international macroeconomics and (cid:222)nance. I hope that I have achieved this goal in some measure and that you (cid:222)nd the book to be of some value. Finally, I would like to express my appreciation to Chi-Young Choi, Roisin O(cid:146)Sullivan and Raphael Solomon who gave me useful comments, and to Horag Choi and Young-Kyu Moh who corrected innumerable (1) mistakes in the manuscript. My very special thanks goes to Donggyu ⇒ Sul who read several drafts and who helped me to set up much of the data used in the book. Contents 1 Some Institutional Background 1 1.1 International Financial Markets . . . . . . . . . . . . . . 2 1.2 National Accounting Relations . . . . . . . . . . . . . . . 15 1.3 The Central Bank(cid:146)s Balance Sheet . . . . . . . . . . . . . 20 2 Some Useful Time-Series Methods 23 2.1 Unrestricted Vector Autoregressions . . . . . . . . . . . . 24 2.2 Generalized Method of Moments . . . . . . . . . . . . . . 35 2.3 Simulated Method of Moments . . . . . . . . . . . . . . 38 2.4 Unit Roots . . . . . . . . . . . . . . . . . . . . . . . . . . 40 2.5 Panel Unit-Root Tests . . . . . . . . . . . . . . . . . . . 50 2.6 Cointegration . . . . . . . . . . . . . . . . . . . . . . . . 63 2.7 Filtering . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 3 The Monetary Model 79 3.1 Purchasing-Power Parity . . . . . . . . . . . . . . . . . . 80 3.2 The Monetary Model of the Balance of Payments . . . . 83 3.3 The Monetary Model under Flexible Exchange Rates . . 84 3.4 Fundamentals and Exchange Rate Volatility . . . . . . . 88 3.5 Testing Monetary Model Predictions . . . . . . . . . . . 91 4 The Lucas Model 105 4.1 The Barter Economy . . . . . . . . . . . . . . . . . . . . 106 4.2 The One-Money Monetary Economy . . . . . . . . . . . 113 4.3 The Two-Money Monetary Economy . . . . . . . . . . . 118 4.4 Introduction to the Calibration Method . . . . . . . . . . 125 4.5 Calibrating the Lucas Model . . . . . . . . . . . . . . . . 126 v vi CONTENTS 5 International Real Business Cycles 137 5.1 Calibrating the One-Sector Growth Model . . . . . . . . 138 5.2 Calibrating a Two-Country Model . . . . . . . . . . . . . 149 6 Foreign Exchange Market Efficiency 161 6.1 Deviations From UIP . . . . . . . . . . . . . . . . . . . . 162 6.2 Rational Risk Premia . . . . . . . . . . . . . . . . . . . . 172 6.3 Testing Euler Equations . . . . . . . . . . . . . . . . . . 177 6.4 Apparent Violations of Rationality . . . . . . . . . . . . 183 6.5 The (cid:145)Peso Problem(cid:146) . . . . . . . . . . . . . . . . . . . . . 186 6.6 Noise-Traders . . . . . . . . . . . . . . . . . . . . . . . . 193 7 The Real Exchange Rate 207 7.1 Some Preliminary Issues . . . . . . . . . . . . . . . . . . 208 7.2 Deviations from the Law-Of-One Price . . . . . . . . . . 209 7.3 Long-Run Determinants of the Real Exchange Rate . . . 213 7.4 Long-Run Analyses of Real Exchange Rates . . . . . . . 217 8 The Mundell-Fleming Model 229 8.1 A Static Mundell-Fleming Model . . . . . . . . . . . . . 229 8.2 Dornbusch(cid:146)s Dynamic Mundell(cid:151)Fleming Model . . . . . . 237 8.3 A Stochastic Mundell(cid:151)Fleming Model . . . . . . . . . . . 241 8.4 VAR analysis of Mundell(cid:151)Fleming . . . . . . . . . . . . . 249 9 The New International Macroeconomics 263 9.1 The Redux Model . . . . . . . . . . . . . . . . . . . . . . 264 9.2 Pricing to Market . . . . . . . . . . . . . . . . . . . . . . 286 10 Target-Zone Models 307 10.1 Fundamentals of Stochastic Calculus . . . . . . . . . . . 308 10.2 The Continuous(cid:151)Time Monetary Model . . . . . . . . . . 310 10.3 In(cid:222)nitesimal Marginal Intervention . . . . . . . . . . . . 313 10.4 Discrete Intervention . . . . . . . . . . . . . . . . . . . . 319 10.5 Eventual Collapse . . . . . . . . . . . . . . . . . . . . . . 320 10.6 Imperfect Target-Zone Credibility . . . . . . . . . . . . . 322 CONTENTS vii 11 Balance of Payments Crises 327 11.1 A First-Generation Model . . . . . . . . . . . . . . . . . 328 11.2 A Second Generation Model . . . . . . . . . . . . . . . . 335 Chapter 1 Some Institutional Background This chapter covers some institutional background and develops some basic relations that we rely on in international macroeconomics and (cid:222)nance. First, you will get a basic description some widely held in- ternational (cid:222)nancial instruments and the markets in which they trade. This discussion allows us to quickly derive the fundamental parity rela- tionsimpliedbytheabsenceofrisklessarbitragepro(cid:222)tsthatrelateasset prices in international (cid:222)nancial markets. These parity conditions are employed regularly in international macroeconomic theory and serve as jumping off points for more in-depth analyses of asset pricing in the international environment. Second, you(cid:146)ll get a brief overview of the nationalincome accountsand their relationto thebalance of payments. Thisdiscussionidenti(cid:222)essomeofthemacroeconomicdatathat wewant theory to explain and that are employed in empirical work. Third, you will see a discussion of the central bank(cid:146)s balance sheet(cid:151)an understand- ing of which is necessary to appreciate the role of international (foreign exchange) reserves in the central bank(cid:146)s foreign exchange market inter- vention and the impact of intervention on the domestic money supply. 1 2 CHAPTER 1. SOME INSTITUTIONAL BACKGROUND 1.1 International Financial Markets Webeginwithadescriptionofsomebasicinternational(cid:222)nancialinstru- ments and the markets in which they trade. As a point of reference, we view the US as the home country. Foreign Exchange Foreign exchange is traded over the counter through a spatially de- centralized dealer network. Foreign currencies are mainly bought and sold by dealers housed in large money center banks located around the world. Dealers hold foreign exchange inventories and aim to earn trad- ing pro(cid:222)tsbybuying lowandsellinghigh. Theforeignexchangemarket is highly liquid and trading volume is quite large. The Federal Reserve Bank of NewYork[51]estimates during April 1998, daily volumeof for- eign exchange transactions involving the US dollar and executed within in the U.S was 405 billion dollars. Assuming a 260 business day calen- dar, this implies an annual volume of 105.3 trillion dollars. The total volume of foreign exchange trading is much larger than this (cid:222)gure be- cause foreign exchange is also traded outside the US(cid:151)in London, Tokyo, and Singapore, for example. Since 1998 US GDP was approximately 9 trillion dollars and the US is approximately 1/7 of the world economy, the volume of foreign exchange trading evidently exceeds, by a great amount, the quantity necessary to conduct international trade. During most of the post WWII period, trading of convertible cur- rencies took place with respect to the US dollar. This meant that converting yen to deutschemarks required two trades: (cid:222)rst from yen to dollars then from dollars to deutschemarks. The dollar is said to be the vehicle currency for international transactions. In recent years cross- currency trading, that allows yen and deutschemarks to be exchanged directly, has become increasingly common. TheforeigncurrencypriceofaUSdollaristheexchangeratequoted in European terms. The US dollar price of one unit of the foreign currencyistheexchangerateisquotedinAmerican terms. InAmerican terms, an increase in the exchange rate means the dollar currency has depreciated in value relative to the foreign currency. In this book, we will always refer to the exchange rate in American terms.