INTERNATIONAL PARITY CONDITIONS

Transcription

1 INTERNATIONAL PARITY CONDITIONS

2 International Parity Conditions Theory, Econometric Testing and Empirical Evidence Imad A. Moosa Senior Lecturer in Economics La Trobe University Australia and Razzaque H. Bhatti Assistant Professor of Economics University of Azad Jammu and Kashmir Pakistan

3 First published in Great Britain 1997 by MACMILLAN PRESS LTD HoundmilIs, Basingstoke, Hampshire RG21 6XS and London Companies and representatives throughout the world A catalogue record for this book is available from the British Library. ISBN ISBN (ebook) DOI / First published in the United States of America 1997 by ST. MARTIN'S PRESS, INC., Scholarly and Reference Division, 175 Fifth Avenue, New York, N.Y ISBN Library of Congress Cataloging-in-Publication Data Moosa, Imad A. International parity conditions: theory, econometric testing and empirical evidence / Imad A. Moosa and Razzaque H. Bhatti. p. cm. Includes bibliographical references and index. ISBN I. Foreign exchange-mathematical models. 2. Purchasing power parity-mathematical models. 3. Interest-Mathematical models. 4. International economic relations-mathematical models. I. Bhatti, Razzaque H., II. Title. HG3823.M '5-dc CIP Imad A. Moosa and Razzaque H. Bhatti 1997 Softcover reprint of the hardcover 1 st edition 1997 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London WI P 9HE. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources I

4 To our Families

5 Contents List of Figures List of Tables Preface xii xiv xv 1 Introduction 1 An Overview The Resurgence of Interest in International ~~~ili~m 4 A Look at the Figures 5 What Follows in this Book 14 2 The Purchasing Power Parity Hypothesis 25 Introduction 25 Absolute and Relative PPP 27 PPP in the History of Economic Thought 30 The Arbitrage. Monetary and Asset Market Views of PPP 32 Ex Ante PPP 36 The Productivity Bias Hypothesis 38 PPP as a Long-Run Equilibrium Condition 39 Proportionality. Symmetry and Exclusiveness 42 The Effect of Different Weights. Non-Traded Goods and Transportation Costs 44 Misinterpretation of Cassel 47 3 The Covered Interest Parity Hypothesis 53 Introduction 53 The CIP Hypothesis: A Formal Exposition 55 The Role of Transaction Costs 58 Less Than Infinite Elasticities 63 Capital Market Imperfections 65 Political Risk 67 Capital Controls 68 Data Imperfections 69 The Role of Speculation 69 The Effect of Taxes 72 Default Risk 73 VII

6 viii Contents Fisherian Expectations 74 The Role of Uncertainty 75 The Role of News 76 4 Uncovered Interest Parity and the Efficient Market Hypothesis 77 Introduction 77 The UIP Hypothesis 78 The Simple Efficiency Hypothesis 79 The General Efficiency Hypothesis 81 Rationalising the Failure of Unbiased Efficiency 82 Some Sources of Bias 89 5 Real Interest Parity and the Fisher Hypothesis 94 Introduction 94 The RIP Hypothesis 95 The Stability of the Fisher Closed Condition 97 Measurement of the Expected Inflation Rate 98 Allowing for Other Factors 101 The Choice of Interest Rate 103 Overlapping vs Non-Overlapping Data 104 The Choice of the Price Index International Parity Conditions in a Cointegration Framework 107 The Basic Idea 107 Historical Review and the Building Blocks 113 Statistical Background 118 The Random Walk Model 119 Stationarity 121 Deterministic and Stochastic Trends 122 Short-Memory and Long-Memory Series 132 The Order of Integration 133 Cointegrated Variables 134 Implications for Conventional Econometric Techniques 139 Cointegration Analysis: The Pros and Cons Testing for Stationarity and Unit Root 143 Introduction 143 The Dickey-Fuller Test 144 The Phillips-Perron Test 148

7 Contents IX The Sims Bayesian Test 151 The Variance Ratio (VR) Test 152 Testing for Seasonal Unit Roots 158 Testing for Unit Root: Further Remarks Cointegration: Representation and Testing 167 More about the Cointegrating Regression 167 Testing for Cointegration: Residual-Based Tests 170 The Johansen Multivariate Method 174 Other Tests for Cointegration 179 Granger's Representation Theorem 181 Seasonal Cointegration and Error Correction Models 184 Cointegration in a Time-Varying Parameter Framework 186 Cointegration and Causality 187 Cointegration and Exogeneity 189 Cointegration and Simultaneous Equation Models 190 Cointegration and Non-Linearities 191 Cointegration and Dynamic Specification 192 Model Building with Integrated Variables: Summary Purchasing Power Parity: Model Specification and Related Econometric Issues 195 Static Specifications 195 Dynamic Specifications 19S The Direction of Normalisation 202 Short-Run vs Long-Run Specifications 204 Structural Changes and Time-Varying Parameters 205 Allowing for Uncertainty 206 Testing PPP in Conjunction with UIP 208 Confusion between Absolute and Relative PPP Purchasing Power Parity: The Empirical Evidence 213 Evidence from the Flexible Exchange Rates of the 1920s 213 Evidence from the post-bretton Woods Flexible Exchange Rates 216 Exchange Rates of the EMS and Other European Countries 226 Other Exchange Rates 228 Long-Run Data 230 Testing the Augmented PPP 234 Concluding Remarks 236

8 x Contents 11 Covered Interest Parity: The Empirical Evidence 239 The Efficient Market Test 239 The Conventional Regression Test 239 Cointegration Analysis 241 The Dynamic Modelling Approach 242 National Currency vs Eurocurrency Assets 243 An Overview of the Empirical Evidence 244 Concluding Remarks Uncovered Interest Parity and the Efficient Market Hypothesis: The Empirical Evidence 252 Conventional Regression Analysis 252 Error Orthogonality Tests 253 Tests Based on Vector Autoregression Analysis 254 Cointegration Analysis 254 Empirical Evidence on Nominal Interest Linkages 255 Empirical Evidence on Unbiased Efficiency: The Flexible Exchange Rates of the 1920s 257 Empirical Evidence on Unbiased Efficiency: The Testing Techniques 259 Empirical Evidence on Unbiased Efficiency: Other Aspects 270 Concluding Remarks Real Interest Parity and the Fisher Hypothesis: The Empirical Evidence 280 Testing the FH: Conventional Regression Analysis 280 Testing the FH: Time-Varying Parametric Regression 284 Testing the FH: Serial Correlation and Orthogonality 285 Testing the FH: Cointegration Analysis 288 Testing the FH: Allowing for Controls and Taxes on Interest Income 291 Testing the FH: Allowing for the Phillips and Friedman Effects 293 Testing the FH: Final Remarks 294 Testing RIP: Conventional Regression Analysis 295 Testing RIP: Orthogonality Tests 298 Testing RIP: Cointegration Analysis 299 Testing RIP: Vector Autoregression Analysis 300 Testing RIP: The Kalman Filter Technique 301 Summary and Concluding Remarks 302

9 Contents 14 Concluding Remarks Recapitulation The Feldstein-Horioka Puzzle Misconceptions about PPP Where Do We Go From Here? Notes References Author Index Subject Index xi

10 List of Figures 1.1 PPP: Japan versus the United States PPP: Germany versus the United States PPP: The United Kingdom versus the United States PPP: Australia versus the United States elp: Japan versus the United States elp: Germany versus the United States elp: The United Kingdom versus the United States elp: Australia versus the United States UIP: Japan versus the United States UIP: Germany versus the United States UIP: The United Kingdom versus the United States UIP: Australia versus the United States RIP: Japan versus the United States RIP: Germany versus the United States RIP: The United Kingdom versus the United States RIP: Australia versus the United States The monetary view of PPP Long-run PPP Short-run PPP Violation of long-run PPP Diagrammatic representation of elp The behaviour of cointegrated variables The behaviour of non-cointegrated variables The attractor A scatter diagram for cointegrated variables A scatter diagram for non-cointegrated variables Possible attractors for PPP The elp attractor with and without taxes The behaviour of the real exchange rate: JapanlUnited States The behaviour of the real exchange rate: Germany/United States The behaviour of the real exchange rate: United Kingdom/United States The behaviour of the real exchange rate: AustralialUnited States 129 xii

11 List of Figures xiii 7.1 The behaviour of the variance ratio of the real exchange rate: JapanlUnited States The behaviour of the variance ratio of the real exchange rate: GermanylUnited States The behaviour of the variance ratio of the real exchange rate: United KingdomlUnited States The behaviour of the variance ratio of the real exchange rate: AustralialUnited States The behaviour of Japanese real interest rate and its components (log level) The behaviour of Japanese real interest rate and its components (first log difference) The behaviour of the autocorrelation functions of Japanese real interest rate and its components (first log difference) Absolute and relative PPP, S = 9(PIP*) Absolute and relative PPP, S = <X + 9(PIP*), <x*0 211

12 List of Tables 6.1 International parity conditions as attractors The behaviour of y, = ~Y'-l + E, The Phillips-Perron Z statistics Frequencies, unit roots and cycles International parity conditions as co integrating regressions Specification of Equations (8.56) and (8.57) Implications of the restrictions on Equations (8.62) and (8.63) 190 xiv

13 Preface This book presents an extensive and up-to-date survey of the theory and empirics of international parity conditions, a subject that has attracted ever-increasing interest on the part of economists, both academic and professional. Although several survey papers have appeared on different parity conditions, only a few attempts have been made to put together and review the vast literature on the four international parity conditions: purchasing power parity, covered interest parity, uncovered interest parity and real interest parity. Such an endeavour is particularly important because the four parity conditions are related to the extent that some of them are necessary conditions for the others. And despite the mushrooming of the literature on the parity conditions the treatment of this topic has been rather fragmented. We thought that writing one volume that encompasses a significant part of the literature on the parity conditions would be of great value to those interested in this topic. We must, however, warn of the hazards of regarding this book as a comprehensive treatment of the topic. The sheer volume of the (published and unpublished) literature on international parity conditions and the relevant methods of empirical testing, together with manuscript constraints, have prevented us from writing a comprehensive piece of work in the strict sense of the word. However, we believe that this is the most complete and integrated piece of work on international parity conditions, given that this topic normally appears as one or a few chapters in books on international finance and international monetary economics. For the same reasons, our treatment may sometimes look superficial, inadequate and lacking in terms of depth and elaboration, particularly concerning some techniques of empirical testing. Again, we must emphasise that the objective is not to present a self-contained 'manual' of international parity conditions but rather a more humble survey of what exists with respect to the theory, methods of econometric testing and empirical evidence. A reader who is interested in pursuing a particular aspect further must consult the original literature, and for this purpose an extensive bibliography is provided. This book was written in Sheffield and Melbourne, starting in the second half of The original idea was to write a book containing a simplified exposition of cointegration analysis using some applications xv

14 xvi Preface to international parity conditions, among others, as illustrations and case studies. Later, we thought that the market lacked a book on international parity conditions, and since this was, and still is, our main field of interest we decided to change the main focus of the book. However, we also decided that the book should contain a simplified illustration of the techniques of testing these conditions for the benefit of those who may not be able to cope with the complexity of the original literature. This seems to be a good place to specify the potential readership of this book. Although this is not meant to be a text, since it is highly specialised, it can be used as supplementary reading for advanced undergraduate or postgraduate courses in international finance and international monetary economics. The main class of readership, however, comprises research students, academics and even practitioners interested in pursuing research on this topic, which has indeed become very popular. The book will certainly provide the means whereby the researcher may avoid going through hundreds of papers in the original literature. Moreover, the part dealing with the methods of econometric testing has been written in a simple way to accommodate the needs of the average applied economist. Sophisticated econometricians, who might feel frustrated by the simplicity of the exposition, could refer to the original literature. Another word of warning is warranted here. The writing of this book finished in March 1996, and since it deals with topics that are developing at an accelerating rate (both the parity conditions and the methods of econometric testing) this book may appear to be out of date soon after publication. However, it will still provide a survey of what has been written on these topics between early this century and early 1996, with special emphasis on developments that have taken place since the beginning of the 1980s. We would like to acknowledge the help we received from friends, colleagues and other individuals both in Sheffield and Melbourne who contributed directly or indirectly to the preparation of this book. Our utmost gratitude must go to Kevin Dowd whose encouragement, advice and generosity with his valuable time was instrumental to our ability to finish this book. Our Friday afternoon meetings with Kevin in Sheffield had the greatest impact on our progress in researching international parity conditions. Moreover, his contribution did not wane after the first author had moved to Melbourne as we kept in touch via . Bob Sedgwick, who has taught both authors, has also contributed significantly throughout what has been a lifetime friendship with the first author. Several other colleagues in Sheffield, some of them

15 Preface xvii without realising, have made some contribution including Sean Holly, Dave Chappell, Dan Hemmings and Ian Baxter. We are particularly grateful to Richard Arden who came to the rescue whenever we needed his extensive knowledge of computing. Paul Mizen of the University of Nottingham allowed us to utilise his young talent by offering us comments on early versions of some chapters as far back as Nabeel AI-Loughani was involved in our work while he spent his sabbatical in Sheffield during the academic year 1993/94. In Melbourne, colleagues were just as generous with their time, providing help whenever possible. So, we would like to thank Colin White, Rod Maddock, Michael Schneider, Keshav Vishwakarma, Param Silvapulle, Sisira Jayasuriya, Harry Clarke, Chongwoo Choe and Pauline Kennedy. We also benefited from the Friday afternoon discussion at the Eagle with Colin Allitt and Gill Hewitson. Lee Smith, an excellent proofreader and research assistant, read the manuscript through with such scrutiny and inquisition that she unveiled a large number of mistakes that would have escaped our attention. Toby Renfrew is another research assistant whose work is embodied in some parts of this book. We utilised Afaf Moosa's computer skills to plug some loopholes in our knowledge of using Microsoft Windows as she converted ugly handdrawn diagrams into nice-looking computer-drawn ones. She also came to the rescue whenever a stumbling block arose throughout the process of keyboarding and editing the manuscript. We must also acknowledge the encouragement we received from Giovanna Davitti, who was the commissioning editor at Macmillan. Her professional attitude made the experience of dealing with a publisher rather pleasant. T.M. Farmiloe, the Publishing Director at Macmillan, was also helpful and flexible and for that we wish to record our gratitude. Finally, we would like to thank our families who had to bear the opportunity cost of producing this book. Just in case some names that deserve to appear here have slipped our memory, we would like to say 'thank you' to all of those who have contributed to making this book come into existence. We must, however, emphasise the usual disclaimer that all remaining errors and shortcomings are entirely ours. IMAD A. MOOSA RAZZAQUE H. BHATII