Journal of International

Money and Finance

ELS EV I ER 17 (1998) 1-3

The pendulum of exchange rate economics

Kees G. Koedijk"

LIFE and Maastricht Unii'ersity, P.O. Box 616, 6200 MD Maastricht, The Netherlands

In the past 25 years since the start of the current float in 1973, professional thinking on nominal and real exchange has swung between extremes. At the outset in the 1970s there was widespread belief that exchange rates would be very stable, not only over the long run, but over the short run as well, and that there would be a stable and predictable relationship with economic fundamentals. The experience with floating exchange rates dismissed that belief. Dornbusch and Frankel (1987) gave the following description of exchange rate behavior:

'The experience with exchange rates over the last 15 years has in many ways differed from what was anticipated in 1973 when the major industrialized countries abandoned the effort to keep the values of their currencies fixed. There is a widespread belief that exchange rates have turned out to be more volatile than they were expected to be, than they should be, and than they need be. Many practitioners believe that exchange rates are driven by psychological factors and other irrelevant market dynamics, rather than by economic fundamentals.'

Ten years of data and estimation techniques later the outlook is less bleak. At least in the medium-run a predictable relationship between exchange rates and economic fundamentals has re-emerged and reintroduced tempered optimism in exchange rate economics.

On April 4 and 5 1997, The Journal of International Money and Finance and the Limburg Institute of Financial Economics (LIFE) of Maastricht University in the Netherlands organized a 2-day workshop on 'Developments in Exchange Rate Modelling'. The conference was organized by Kees Koedijk of Maastricht Univer- sity, James R. Lothian of Fordham University and Michael Melvin of Arizona State University. The workshop was broad and encompassed a wide variety of topics related to exchange rate modelling. The papers presented dealt with the micro- structure of the foreign exchange market, the intervention behavior of central banks, real exchange rates, foreign exchange options and uncovered interest parity. A selection of the papers presented at the conference is included in this issue. A

* Tel.: + 31 43 3883862; fax: + 31 43 3258530; e-mail: c.koedijk@BERFIN.Unimaas.nl

0261-5606/98/$19.00 0 1998 Elsevier Science B.V. All rights reserved. P I I: S 0 2 6 1 - 5 6 0 6 ( 9 7 ) 0 0 0 5 9 - 4

2 K. G. Koedijk /Journal of International Money and Finance 17 (1998) 1-3

roundtable discussion on purchasing power parity (PPP) was also part of the workshop. Short papers on PPP were presented by James Lothian, by David Papell and Hristos Theodoridis, by Kees Koedijk, Peter Schotman and Mathijs van Dijk, and by Akhtar Siddique and Richard Sweeney.

As is well-known, PPP is one of the oldest topics in international economics. When exchange rates started to float worldwide in 1973, it was widely believed that exchange rates would adjust according to relative prices. The years of high volatility quickly destroyed that idea. The demise of PPP as a practical guide to exchange rate behavior was further confirmed through formal econometric tests. In the early 1980s, it seemed as if the theory of PPP had collapsed completely.

In the past decade, tests of PPP have often taken the form of unit root tests of real exchange rates. As is well-known (see for example the excellent review of Edison et al. (1997) in this journal), these tests typically suffer from extreme low power. Researchers reacted to the low power problem by using long-horizon data. This is also the approach summarized and taken in Lothian (1998). Based on his own work and the studies using long historical data sets, Lothian concludes that real exchange rates in fact contain economically important mean-reverting compo- nents and that PPP, as a result is still a useful first approximation. Moreover, Lothian shows that the difficulty of finding evidence of PPP with the United States dollar as the numeraire currency is primarily caused by the 1979-1982 period during which the dollar first strongly depreciated and afterwards strongly appreci- ated.

An alternative way to circumvent the low power of traditional tests has been the use of panel data. Examples in this vein are Jorion and Sweeney (1996) and Frankel and Rose (1996). The panel approach is also followed in Papell and Theodoridis (1998). Using samples of data which begin in 1973 and end between 1982 and 1996 they find that, as the sample is extended, the evidence of PPP is extended. Interestingly, Papell and Theodoridis report that evidence is uniformly stronger when the mark is used as the base.

Recently, panel tests of PPP have been questioned by O’Connell (19971, who showed that the standard practice of calculating all real exchange rates relative to the US dollar leads to cross-sectional dependence in time series panel data. Adjusting for this problem makes it much more difficult to reject the random walk in real exchange rates. Koedijk et al. (1998) introduce a panel data methodology that explicitly deals with the numeraire effect that causes the cross-sectional dependence. Looking at data for 17 currencies between 1972 and 1996 they find that there is substantive evidence that PPP holds for many currencies, although not for every currency to the same extent. The least evidence in favor of PPP is found when the Japanese yen is used as numeraire. Evidence in favor of PPP becomes stronger at horizons longer than 1 year. Koedijk et al. (1998) conclude that research should now try to explain why PPP holds within currency blocs and not between them. Candidate explanations are the fact that goods arbitrage is more effective within currency blocs and the fact that volatility is lower.

Given the considerable evidence that PPP might hold after all, Siddique and Sweeney (1998) take up the acid test and investigate the forecastability of real

K. G. Koedijk /Journal of International Money and Finance 17 (1998) 1-3 3

exchange rates. Siddique and Sweeney report that longer time horizons improve the performance of the estimated forecast models relative to the driftless random walk. They conclude that the forecasting ability of PPP is genuine, but that the models resolve only a small part of the uncertainty regarding the evolution of real exchange rates. They stress that business or government forecasters must note that the mean reversion component of real rate movements can easily be overwhelmed in the short run by random shocks and that, even over a long horizon, two-stan- dard-error bands can be very wide.

References

Dornbusch, R., Frankel, J.A., 1987. The flexible exchange rate system, experience and alternatives.

Edison, H.J., Gagnon, J.E., Melick, W.R., 1997. Understanding the empirical literature on purchasing

Frankel and Rose, 1996. A panel project on purchasing power: Mean reversion until and between

Jorion, P., Sweeney, R.J., 1996. Mean reversion in real exchange rates: evidence and implications. J. Int.

Koedijk, K.G., Schotman, P.C., Van Dijk, M., 1998. The reemergence of purchasing power parity in the

Lothian, J.R., 1998. Some new stylized facts of floating exchange rates. J. Int. Money Finance (in press). O’Connell, P.G.J., 1997. The overvaluation of purchasing power parity. J. Int. Econ. (in press). Papell, D.H., Theodoridis, H., 1998. Increasing evidence of purchasing power parity over the current

Siddique, A,, Sweeney, R.J., 1998. Forecasting real exchange rates. J. Int. Money Finance (in press).

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