Structural Breaks in the Real Exchange Rate and Real Interest Rate Relationship

In this paper we empirically examine the relationship between the real exchange rate and real interest rate differentials using recent econometric methods robust to potential structural breaks. Generally, our study provides evidence of this relationship in the long-run context. More specifically, we first focus on the UK-US relationship, and interestingly find limited evidence of this long-run relationship using traditional methods. But when an approach robust to endogenously determined structural breaks is employed, we find evidence that the real interest rate differential is an important determinant of the real exchange rate. Secondly, in order to investigate the relevance of structural shifts in a more global context, we carry out multiple country analysis. While providing evidence of this long-run relationship, European data suggest that the presence of structural breaks is not very common across countries and is indeed country-specific.

A New Test of the Real Interest Rate Parity Hypothesis: Bounds Approach and Structural Breaks

We test the real interest rate parity hypothesis using data for the G7 countries over the period 1970-2008. Our contribution is two-fold. First, we utilize the ARDL bounds approach of Pesaran et al. (2001) which allows us to overcome uncertainty about the order of integration of real interest rates. Second, we test for structural breaks in the underlying relationship using the multiple structural breaks test of Bai and Perron (1998, 2003). Our results indicate significant parameter instability and suggest that, despite the advances in economic and financial integration, real interest rate parity has not fully recovered from a breakdown in the 1980s.

Interest Rate Co-movements, Global Factors and the Long End of the Term Spread

The disconnect between rising short and low long interest rates has been a distinctive feature of the 2000s. Both research and policy circles have argued that international forces, such as global monetary policy (e.g. Rogoff, 2006); international business cycles (e.g. Borio and Filardo, 2007); or a global savings glut (e.g Bernanke, 2005) may be responsible. In this paper, we employ recent advances in panel data econometrics to document the disconnect and link it explicitly to the existence of a global latent factor that dominates the long end of the term spread for the recent period; the saving glut story emerges as the most likely contender for the global factor.

Learning about Risk and Return: A Simple Model of Bubbles and Crashes

This paper demonstrates that an asset pricing model with least-squares learning can lead to bubbles and crashes as endogenous responses to the fundamentals driving asset prices. When agents are risk-averse they need to make forecasts of the conditional variance of a stock’s return. Recursive updating of both the conditional variance and the expected return implies several mechanisms through which learning impacts stock prices. Extended periods of excess volatility, bubbles and crashes arise with a frequency that depends on the extent to which past data is discounted. A central role is played by changes over time in agents’ estimates of risk.

Nominal Interest Rates and Stationarity

This paper investigates the (break) stationarity null hypothesis using data for 25 interest rates with different maturities and risk characteristics in Canada and the US. In contrast to a large part of the literature, this paper reports strong empirical evidence in favour of the null hypothesis of stationarity for the interest rate series.

On Identification of Bayesian DSGE Models

In recent years there has been increasing concern about the identification of parameters in dynamic stochastic general equilibrium (DSGE) models. Given the structure of DSGE models it may be difficult to determine whether a parameter is identified. For the researcher using Bayesian methods, a lack of identification may not be evident since the posterior of a parameter of interest may differ from its prior even if the parameter is unidentified. We show that this can even be the case even if the priors assumed on the structural parameters are independent. We suggest two Bayesian identification indicators that do not suffer from this difficulty and are relatively easy to compute. The first applies to DSGE models where the parameters can be partitioned into those that are known to be identified and the rest where it is not known whether they are identified. In such cases the marginal posterior of an unidentified parameter will equal the posterior expectation of the prior for that parameter conditional on the identified parameters. The second indicator is more generally applicable and considers the rate at which the posterior precision gets updated as the sample size (T) is increased. For identified parameters the posterior precision rises with T, whilst for an unidentified parameter its posterior precision may be updated but its rate of update will be slower than T. This result assumes that the identified parameters are pT-consistent, but similar differential rates of updates for identified and unidentified parameters can be established in the case of super consistent estimators. These results are illustrated by means of simple DSGE models.

Large Time-Varying Parameter VARs

In this paper we develop methods for estimation and forecasting in large timevarying parameter vector autoregressive models (TVP-VARs). To overcome computational constraints with likelihood-based estimation of large systems, we rely on Kalman filter estimation with forgetting factors. We also draw on ideas from the dynamic model averaging literature and extend the TVP-VAR so that its dimension can change over time. A final extension lies in the development of a new method for estimating, in a time-varying manner, the parameter(s) of the shrinkage priors commonly-used with large VARs. These extensions are operationalized through the use of forgetting factor methods and are, thus, computationally simple. An empirical application involving forecasting inflation, real output, and interest rates demonstrates the feasibility and usefulness of our approach.

How Optimal is US Monetary Policy?

Most of the literature estimating DSGE models for monetary policy analysis assume that policy follows a simple rule. In this paper we allow policy to be described by various forms of optimal policy - commitment, discretion and quasi-commitment. We find that, even after allowing for Markov switching in shock variances, the inflation target and/or rule parameters, the data preferred description of policy is that the US Fed operates under discretion with a marked increase in conservatism after the 1970s. Parameter estimates are similar to those obtained under simple rules, except that the degree of habits is significantly lower and the prevalence of cost-push shocks greater. Moreover, we find that the greatest welfare gains from the ‘Great Moderation’ arose from the reduction in the variances in shocks hitting the economy, rather than increased inflation aversion. However, much of the high inflation of the 1970s could have been avoided had policy makers been able to commit, even without adopting stronger anti-inflation objectives. More recently the Fed appears to have temporarily relaxed policy following the 1987 stock market crash, and has lost, without regaining, its post-Volcker conservatism following the bursting of the dot-com bubble in 2000.

A Simple Characterization of Dynamic Completeness in Continuous Time

This paper investigates dynamic completeness of financial markets in which the underlying risk process is a multi-dimensional Brownian motion and the risky securities dividends geometric Brownian motions. A sufficient condition, that the instantaneous dispersion matrix of the relative dividends is non-degenerate, was established recently in the literature for single-commodity, pure-exchange economies with many heterogenous agents, under the assumption that the intermediate flows of all dividends, utilities, and endowments are analytic functions. For the current setting, a different mathematical argument in which analyticity is not needed shows that a slightly weaker condition suffices for general pricing kernels. That is, dynamic completeness obtains irrespectively of preferences, endowments, and other structural elements (such as whether or not the budget constraints include only pure exchange, whether or not the time horizon is finite with lump-sum dividends available on the terminal date, etc.)

Currency Forecast Errors at Times of Low Interest Rates: Evidence from Survey Data on the Yen/Dollar Exchange Rate

Using survey expectations data and Markov-switching models, this paper evaluates the characteristics and evolution of investors' forecast errors about the yen/dollar exchange rate. Since our model is derived from the uncovered interest rate parity (UIRP) condition and our data cover a period of low interest rates, this study is also related to the forward premium puzzle and the currency carry trade strategy. We obtain the following results. First, with the same forecast horizon, exchange rate forecasts are homogeneous among different industry types, but within the same industry, exchange rate forecasts differ if the forecast time horizon is different. In particular, investors tend to undervalue the future exchange rate for long term forecast horizons; however, in the short run they tend to overvalue the future exchange rate. Second, while forecast errors are found to be partly driven by interest rate spreads, evidence against the UIRP is provided regardless of the forecasting time horizon; the forward premium puzzle becomes more significant in shorter term forecasting errors. Consistent with this finding, our coefficients on interest rate spreads provide indirect evidence of the yen carry trade over only a short term forecast horizon. Furthermore, the carry trade seems to be active when there is a clear indication that the interest rate will be low in the future.

Social norms, morals and self-interest as determinants of pro-environment behaviour.

This paper considers the role which selfish, moral and social incentives and pressures play in explaining the extent to which stated choices over pro-environment behaviours vary across individuals. The empirical context is choices over household waste contracts and recycling actions in Poland. A theoretical model is used to show how cost-based motives and the desire for a positive self- and social image combine to determine the utility from alternative choices of recycling behaviour. We then describe a discrete choice experiment designed to empirically investigate the effects such drivers have on stated choices. Using a latent class model, we distinguish three types of individual who are described as duty-orientated recyclers, budget recyclers and homo oeconomicus. These groups vary in their preferences for how frequently waste is collected, and the number of categories into which household waste must be recycled. Our results have implications for the design of future policies aimed at improving participation in recycling schemes.

An Empirical Assessment of Optimal Monetary Policy Delegation in the Euro Area

We estimate a New Keynesian DSGE model for the Euro area under alternative descriptions of monetary policy (discretion, commitment or a simple rule) after allowing for Markov switching in policy maker preferences and shock volatilities. This reveals that there have been several changes in Euro area policy making, with a strengthening of the anti-inflation stance in the early years of the ERM, which was then lost around the time of German reunification and only recovered following the turnoil in the ERM in 1992. The ECB does not appear to have been as conservative as aggregate Euro-area policy was under Bundesbank leadership, and its response to the financial crisis has been muted. The estimates also suggest that the most appropriate description of policy is that of discretion, with no evidence of commitment in the Euro-area. As a result although both ‘good luck’ and ‘good policy’ played a role in the moderation of inflation and output volatility in the Euro-area, the welfare gains would have been substantially higher had policy makers been able to commit. We consider a range of delegation schemes as devices to improve upon the discretionary outcome, and conclude that price level targeting would have achieved welfare levels close to those attained under commitment, even after accounting for the existence of the Zero Lower Bound on nominal interest rates.

An Empirical Assessment of Optimal Monetary Policy Delegation in the Euro Area

We estimate a New Keynesian DSGE model for the Euro area under alternative descriptions of monetary policy (discretion, commitment or a simple rule) after allowing for Markov switching in policy maker preferences and shock volatilities. This reveals that there have been several changes in Euro area policy making, with a strengthening of the anti-inflation stance in the early years of the ERM, which was then lost around the time of German reunification and only recovered following the turnoil in the ERM in 1992. The ECB does not appear to have been as conservative as aggregate Euro-area policy was under Bundesbank leadership, and its response to the financial crisis has been muted. The estimates also suggest that the most appropriate description of policy is that of discretion, with no evidence of commitment in the Euro-area. As a result although both ‘good luck’ and ‘good policy’ played a role in the moderation of inflation and output volatility in the Euro-area, the welfare gains would have been substantially higher had policy makers been able to commit. We consider a range of delegation schemes as devices to improve upon the discretionary outcome, and conclude that price level targeting would have achieved welfare levels close to those attained under commitment, even after accounting for the existence of the Zero Lower Bound on nominal interest rates.

Primary Commodity Prices: Co-movements, Common Factors and Fundamentals

The behavior of commodities is critical for developing and developed countries alike. This paper contributes to the empirical evidence on the co-movement and determinants of commodity prices. Using nonstationary panel methods, we document a statistically significant degree of co-movement due to a common factor. Within a Factor Augmented VAR approach, real interest rate and uncertainty, as postulated by a simple asset pricing model, are both found to be negatively related to this common factor. This evidence is robust to the inclusion of demand and supply shocks, which both positively impact on the co-movement of commodity prices.

US Monetary and Fiscal Policies - Conflict or Cooperation?

Most of the literature estimating DSGE models for monetary policy analysis ignores fiscal policy and assumes that monetary policy follows a simple rule. In this paper we allow both fiscal and monetary policy to be described by rules and/or optimal policy which are subject to switches over time. We find that US monetary and fiscal policy have often been in conflict, and that it is relatively rare that we observe the benign policy combination of an conservative monetary policy paired with a debt stabilizing fiscal policy. In a series of counterfactuals, a conservative central bank following a time-consistent fiscal policy leader would come close to mimicking the cooperative Ramsey policy. However, if policy makers cannot credibly commit to such a regime, monetary accommodation of the prevailing fiscal regime may actually be welfare improving.