presentation slides by 31 october by prof macdonald

7/31/2019 Presentation Slides by 31 October by Prof MacDonald

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Equilibrium ExchangeRates and Exchange Rate

ForecastingRonald MacDonald

University of Strathclyde


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Introduction

Main theme of lecture: macroeconomicfundamentals useful for determination ofexchange rates at long (equilibrium) and

medium-run (forecasting) horizons.

Controversial as seems to go againstcurrent conventional wisdom (CCW).

What is CCW?


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Introduction

CCW argues for the abandonment ofmacroeconomic fundamentals foranalysing exchange rate movements.

CCW takes as its starting point dailyvolume of global foreign exchangetransactions = $1.2 trillion

Given on daily basis macro-fundamentalsdont change much - How explain $1.2T?Move to Market Microstrucure (MM).


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Introduction

MM focuses on institutional features of theForex inter-bank behaviour; inter-bank / broker.Two key MM variables are bid-ask measure of

transaction costs - and order flow measure ofinformation flow.

Theoretical MM literature focuses on det. of B-Aand influence of order flow on volatility.

Highlights Heterogeneity vs. Homogeneity ofexpectations Important.


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Introduction

Empirical literature provides support forinfluence of order flow on volatility-volumeand B-A. So perhaps MM helpful for

explaining high frequency volatility. But time frame day so not helpful for

predictability or equilibrium.

The new CCW arose because of theexistence of the so-called Exchange RateDisconnect. This has three aspects:


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Introduction

1. Volatility: Exchange rates when flexible areexcessively volatile. Intra- and inter-regimeaspects.

2. Level: Exchange rates unpredictable athorizons of < 3 years - relates to forecasting andMeese and Rogoff Random walk result.

3. PPP Puzzle: If PPP taken as measure ofequilibrium then equilibrium is ill-defined meanreversion too slow i.e. life too large.


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Introduction

I intend focussing on 2 aspects of theexchange rate disconnect Level andPPP puzzle.

Will argue: can forecast currencies usingmacro fundamentals as short as 2 monthhorizons; produce sensible measure of

equilibrium if abandon PPP and focus on areal exchange rate relationship.


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Introduction

The issue of an equilibrium exchange rate, andthe related concept of misalignment, is ofinterest to policy makers/ central banks/ financial

institutions. Forecastability of currencies of interest to

financial institutions such as hedge funds.Recently returns from international portfolios

have often come from exchange ratemovements so getting these right important.


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Equilibrium Exchange Rates

Why is the concept of equilibrium of interest?

Issues of misalignment in managed floatuseful to have indicator for on-going policy

debate. Issues of joining a currency union or locking

currency to a monetary standard. History repletewith example of countries getting this wrong (UKin 1926 and again in 1992)


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How Measure Equilibrium?

Purchasing Power Parity (PPP) firstmeasure Economists reach for.

Is it useful? To answer think of derivation.

*

t t tS P P

*

0t t t t Q S P P


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Relies on Law of One Price (LOOP)

LOOP Arbitrage + Substitutability

Arbitrage: Individual and Wholesale issues- Are Traded goods PerfectlySubstitutable?

What Does the Empirical Evidence say?

LOOP violated for all but generic goods(i.e. commodities).


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PPP Puzzle therefore not surprising How explain?

Straightforward to decompose real exchange rate:

i. QTTrading frictions: Impart neutral band Qfollows non-linear process. Quite a bit of evidence infavour of this view but issues of arbitrage andsubstitutability.


,T T NT

t t tQ Q Q


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ii. Real Factors a) QT,NTBest knownBalassa-Samuelson. TFP shocks in tradedsector generates appreciation of CPI-

based Qimpart systematic trend.

Evidence: 1. Indirect: Studies using pricedata suggest it is movements in QTexplain

violations of PPP.


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2. Direct: build TFP from OECD sectoral database CPI-based qand qT,NT. Studies reportsignificant evidence of importance of Balassa-Samuelson effect + adjustment speeds/ life

faster with BS. Real Factors b) QTFailure of LOOP means

driven by NFA or TB.A lot of evidencesupportive of this + life faster.

iiiQT

Market structure i.e. PTM and passthrough. Empirical evidence shows meanreversion speed significantly related to marketstructure.


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Equilibrium: in search of a suitableacronym.

In thinking about equilibrium issues otherapproaches take explicitly real perspective.

Internal External Balance Best knownFundamental Equilibrium Exchange Rate or

FEER. FEER is Q consistent with both internal and

external balance in medium run (5 years hence)- not stock-flow equilibrium.

IB = high employment + low inflation. EB:sustainable desired net flow of resourcesbetween countries when in internal balance.


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Issues with FEER.

1. CAP sustainability controversial - Williamson usesvariety of factors such as Investment needs, effect ofdemographics on savings.

2. Method of calculation: does not actually say how Qconverges to FEER,

3. Depends on underlying trade elasticities veryimprecise

4. not clear how good implicit ex rate relationship is. 5. Normative approach. Useful to have approach which

separates the behavioural from normative.

6. Micro foundations?


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BEER Approach of Clark and MacDonald(1999,2000). Sequence: 1. Take standardbehavioural real exchange rate model.

2. Use best practice econometrics to estimatemodel.

3. Use this for assessment purposes - therebyseparating positive from normative. General

framework for assessment issues. 4. Show real factors important since mean

reversion speeds fast: life 1 year or less.


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Permanent Equilibrium Exchange Rates:PEERs

Rely on decomposing Q into permanent and

transitory components. Interpret the former as ameasure of equilibrium:

where QPpermanent component; QT is

transitory. Advantages straightforward. Disadvantages

lack of theoretical underpinnings.

p T

t t tQ Q Q


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A capital enhanced equilibrium exchangerate, or CHEER [UIP/PPP].

Focuses on x=[s,p,p*,Il, il*]

Produces sensible measures ofequilibrium in sense that homogeneityrestrictions can be imposed on prices and

sensible coefficients on idiff. Useful in presence of limited data, but

limited in terms of structure.


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New Open Economy Macroeconomic Approach(NOEM) to Assessment Issues.

Basic idea: optimising behaviour of consumers hasimplications for CA which, in turn, has implications forexchange rates.

Optimising rule of consumers suggests elasticity ofsubstitution, , is key determines how relative price ofT to NT affects rel quantaties.

Given and required in consumption of traded goodsshow how much ofQ needed to restore currentbalance.

Advantages theoretically rigorous. Disadvantages: whatis ? and as in FEER normative.


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Summary of Equilibrium exchangerate Issues

1. Measure useful for assessmentpurposes/ locking currencies together.

2. PPP not a suitable vehicle. Lesson of

mean reversion important. 3. Use a measure which makes the

normative/ positive split transparent.

BEER PEER? 4. Perhaps use a range of indicators and

produce weighted average?


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Exchange Rate Forecasting

Since Meese and Rogoff (1984) Forecastingexercises usually defined w.r.t. Random Walkthe acid test. Can the profession beat it?

A lot of eyeball evidence in favour ofapproximate random walk. But issue of timedimension 1, 2 ,3 months? See Figures.

Econometric evidence gauges forecastabilityusing RMSE criterion:

1t t tS S


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The RMSE criterion is:

How useful? Direction perhaps more so.

But this is benchmark in academic literature. How good are the professionals see the

distributions for professionals.

From Consensus Economics, period -.

RMSEF A

n

t t ( )

2

RMSERMSE

RMSE

rm

rw


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Econometric work has as starting point study ofMeese and Rogoff (1984) who take variants ofthe monetary model i.e.:

For USD of DM, Yen and , M+R unable tooutperform a random walk at horizons of

between one and 12 months ahead Since M+R gave models an unfair advantage

random walk very strong.

* * *[( ),( ),( )]s f m m y y i i


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Update surveying post M+R:

Frankel and Rose (1995) ...the Meeseand Rogoff analysis of short horizons [less

than 36 months] has never beenconvincingly overturned or explained. Itcontinues to exert a pessimistic effect onthe field of empirical exchange ratemodeling in particular and internationalfinance in general

Rogoff (1999) reaffirms this.


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Although Frankel and Rose quote typifiesview in profession, now numerous papers(over 30) using monetary model which

have overturned this result:

Why discounted?

Seems to be view in profession that we

need new conventional wisdom mentionedat start of lecture.


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Because of RW result, Obstfeld and Rogoff andFlood and Rose suggest moving from macrofundamentals to market microstrucure.

But does this thrown baby out with bath water? Why the random walk result? M+R and all those

who are unable to outperform use simple staticmodels.

But exchange market, and underlying, marketsinherently dynamic. So should recognise this inany estimation.


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Take MacDonald and Marsh Model UIP/CIP

x=[s,p,p*,Il, il*]

Dynamic:

V=[xt,xt-1, x]

Key advantage of strategy:

1. gives full system of equations, for all variables, ratherthan a single reduced form.

2. Facilitates a stringent test of forecast ability sincepredicted values of all terms (exchange rates, prices andinterest rates) are used rather than actual data values.


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Currencies : yen, DM and against USD, Jan1974 to December 1992, last 24 obs held backfor forecasting purposes.

The forecasts fully simultaneous and dynamic

and could therefore have been used by apotential forecaster. Also significance levels offorecasting performance are provided.

Criteria:

1. RMSErrelative to a random walk 2. In terms ofdirectional ability:

Dn

(1 if forecast direction = actual,else 0)


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Pure Chance: D = 0.5

3. RMSErRelative to a panel of 150professional forecasters, located in G7 financialcentres, as collected by Consensus Economicsof London.

Summary of Findings: 1. Able to beat a randomwalk at horizons as short as 2 months aheadand this continues to longer horizons.


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2. Models have excellent directional ability on average between 0.6 and 0.7 overthe different horizons

3. No forecaster ranks as consistentlyhighly across currencies and/ or horizons.


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The essential point of this modeling: an Smodel which has sensible long-runequilibrium and dynamic properties, rich

enough to capture the underlying marketdynamics, will do better than a staticmodel or one with very simple dynamics.

Modelling approach has been usedextensively by financial institutions andforecastability seems robust over time.


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Summary and Conclusions

Main theme of todays lecture has been to have

argued against the current conventional wisdomin the exchange rate economics literature.

Tried to argue that standard macrofundamentals are useful for an analysis ofexchange rate behaviour.

Specifically we have argued that it is possible toaddress the Exchange Rate Disconnect.


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Specifically, I argued that PPP on its own is nota sufficient measure for thinking aboutequilibrium issues but there are alternatives.

These alternatives explicitly recognises that realexchange rates have real determinants.

They have an exotic array of mnemonics fromBEERs to FEERs to Cheers. Useful forassessment issues and for currency locks.


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We have also argued that the reason sofew researchers have been able to beat arandom walk model is because of the very

simplistic empirical models used. Realistic dynamic models are able to

outperform a random walk and offer gooddirectional performance.

Such models should be of use topractitioners.


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In sum, the current trend in the professiontowards market microstructure issues isworthwhile and interesting.

However, to abandon a role formacroeconomic fundamentals istantamount to ignoring key information in

the process of exchange ratedetermination.

presentation slides by 31 october by prof macdonald

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