can learning affect exchange rate behavior the case of the dollar in the early 1980 s this paper demonstrates that a change in parameters of the money market that is not immediately understood will affect the behavior of exchange rate forecast errors while the market is learning the analysis is applied to the behavior of u s dollar german mark forecast errors during the early 1980 s when the market appeared to systematically underpredict the strength of the dollar consistent with this observation empirical estimates of implied forecast errors based upon bayesian learning suggest that forecast errors would have been on average negative during the period as the market came to realize the increase in u s money demand

forward exchange bias hedging and the gains from international diversification of investment portfolios abstract the gains to the us investor from international diversification of investment portfolios are examined for portfolio strategies that hedge and strategies that do not hedge exchange rate risk via the interbank forward market using the sharpe performance index and stochastic dominance as performance measures almost all the unhedged strategies outperformed the hedged strategies for 1985 1988 the opposite held for 1981 1984 the results are explained by the biasedness of forward rates in predicting future spot rates jel f30

estimation and simulation of risk premia in equity and foreign exchange markets abstract there is substantial evidence to reject constant risk premia financial models while time varying risk premia are often mentioned as an alternative the literature has yet to produce an example that accounts for the important time series properties of asset returns we inquire whether mean variance optimization models can do so we model asset risk with an absolute error version of the arch in mean hypothesis and model hedging motives that derive from variation in future real income and inflation to account for agent heterogeneity we consider a three country and two asset world our model predicts values for five excess returns relative to the us bill rate we use a systems approach to estimate the model parameters and then simulate the estimated model to determine if it can account for the important time series properties of risk premia

green growth and the efficient use of natural resources abstract the relatively new concept of green growth can be fruitfully connected to concepts and theories in neoclassical economics including market externalities ricardian and hotelling rents and policies that would correct externalities such as pigovian taxes or a cap and trade system set to achieve emissions reductions consistent with cost benefit assessment partial equilibrium concepts have been extended to general equilibrium models including their realization in relatively detailed empirical models that faithfully adhere to theoretical concepts of neoclassical economics with such models we are then able to see how resource depletion and environmental degradation are affecting the economy and how efforts to reduce the impact of these environmental and resource constraints could improve economic growth and performance the foundation for traditional computable general equilibrium models are the national income and product accounts nipas input output i o tables and expanded social accounting matrices sams the basis for extending these to include environmental and resource assets and goods are so called integrated economic and environmental social accounts ieesas while environmental effects are often considered to be non market many of the impacts of environment are often reflected in market accounts through damages that might include for example less labor due to environment related health problems reduced productivity of agroecosystems or damage to infrastructure and other produced assets the challenge is to make the environmental connection explicit so as to provide a guide to where changes in policies could provide benefit however some damages do not enter the accounts at all and mainly this is because household labor and leisure time are generally not valued in traditional accounts hence the cost of illness in terms of reduced ability to contribute to household activities would be missed in the standard accounts while the theoretical structure for expanding the accounts has been laid out in various reviews the empirical challenge of doing so is substantial careful attention to expanding nipa accounts making it a regular part of government statistical agencies efforts would improve the foundation for analysis of potential green growth policies and measures

heterogeneity and volatility puzzles in international finance we develop an equilibrium model in a 2 country 2 good pure exchange economy in which investors with logarithmic utility functions have heterogeneous beliefs about exogenously given output or endowment processes we obtain closed form representations of real ex change rates and of stock prices we show that heterogeneous beliefs together with hetero geneous preferences make the volatility of real exchange rates and of stocks exhibit some properties that have been well documented in the empirical literature these properties include the high volatility of both real exchange rates and stocks compared with that of economic fundamentals the high correlation of stocks during periods of volatile markets the model can also generate the clustering of the volatility of foreign exchange rates and stocks if the differences of beliefs are clustering

empirical tests of the monetary approach to exchange rate determination there has been much discussion as to whether or not the turbulence in foreign exchange rates that has existed since 1973 is consistent with an efficient foreign exchange market this empirical question can only be tested relative to an equilibrium exchange rate model in this paper we conduct variance tests and efficient markets tests of three different models of exchange rate determination the equilibrium rational expectations model ere the currency substitution model cs and dornbusch s exchange rate dynamics model erd we find that the uncertainty in realised exchange rate movements can only be explained by the erd model and that actual exchange rates could have been predicted in a manner that is inconsistent with the efficient markets hypothesis

stock market returns and inflation evidence from other countries this paper investigates the relation between common stock returns and inflation in twenty six countries for the postwar period our results do not support the fisher hypothesis which states that real rates of return on common stocks and expected inflation rates are independent and that nominal stock returns vary in one to one correspondence with expected inflation there is a consistent lack of positive relation between stock returns and inflation in most of the countries

international stock market linkages evidence from the pre and post october 1987 period abstract this paper uses recent developments in the theory of cointegration to provide new methods of testing the linkage and dynamic interactions among stock market movements our findings are in sharp contrast with previous research which discovered strong interdependence among national stock markets prior to october 1987 for the post october 1987 period however our results show that the degree of international co movements among stock price indices has increased substantially with the nikkei index the only exception furthermore the us stock market is found to have a considerable impact on the french german and uk markets in the post crash period we also find the response of the french german and uk markets to us stock market innovations to be consistent with the view of cross border informationally efficient stock markets finally we find the japanese equity market performance to have no links with both the us stock market and the stock markets in france germany and uk during the pre and post october crash period

in search of the exchange risk premium a six currency test assuming mean variance optimization abstract a number of authors examining deviations of actual rates of currency depreciation from forward discounts have claimed to find evidence of risk premiums if these deviations are indeed partly due to risk premiums rather than being entirely due to expectational errors then they should be systematically related to those variables on which risk premiums are thought to depend finance theory tells us that if investors optimize with respect to mean and variance the risk premium depends in a specific way on 1 the supplies of assets denominated in the various currencies 2 the variance covariance matrix of the rates of return and 3 the coefficient of risk aversion the null hypothesis of this paper is that the coefficient of risk aversion is zero countries assets are perfect substitutes and risk premiums are nonexistent the alternative hypothesis is that rates of return are systematically related to asset supplies by a macroeconomic portfolio balance function the maximum likelihood technique used dominates previous attempts to find such a relationship in that the parameters of the portfolio balance function are constrained to depend on the variance covariance matrix as the finance theory says they should on the other hand the technique also dominates previous applications of the finance theory in that the expected returns are allowed to vary over time as the macroeconomic portfolio balance theory says they should the paper s finding is a statistical inability to reject the null hypothesis for a portfolio of six currencies although this could be due to low power in the test

a note on exchange rate expectations and nominal interest differentials a test of the fisher hypothesis this note tests the hypothesis that nominal interest differentials between similar assets denominated in different currencies can be explained entirely by the expected change in the exchange rate over the holding period this proposition often called the fisher open hypothesis or the hypothesis of perfect asset substitutability has been a major component of recent theories of exchange rate determination and has important implications for monetary policy 1 the fisher hypothesis differs from the covered interest parity theorem enunciated by keynes 11 while covered interest parity equates the nominal interest differential between financial centers to a known premium or discount on forward foreign exchange and is thus in principle riskless fisher parity involves risk in an essential way the two conditions are equivalent only when forward exchange rates equal expected future spot rates recent theoretical work for example that of grauer litzenberger and stehle 8 kouri 12 and frankel 6 shows that this need not be the case when market participants are risk averse thus while covered interest parity must always hold exactly in an informationally efficient asset market with no transactions costs fisher parity need not nominal interest differentials may reflect risk premia in addition to expected exchange rate movements 2 it should be emphasized at the outset that the tests conducted in this paper are really joint tests of the fisher hypothesis and a weak form of foreign exchange market informational efficiency levich 14 has argued that tests of market efficiency are always joint tests involving some hypothesized structure of normal equilibrium returns below we assume informational efficiency and instead test fisher s hypothesized arbitrage condition that nominal interest differentials equal expected percentage changes in exchange rates

common stochastic trends in international stock markets abstract this paper presents evidence concerning the number of common stochastic trends in the equity markets of the u s japan england germany and canada monthly and quarterly data from january 1974 through august 1990 on morgan stanley s capital international indices are used to compute johansen 1990 tests for common trends the results indicate the presence of a single common trend driving these countries stock markets estimates of the factor loadings suggest that this trend is most important in the japanese market and least important in the canadian market to interpret this evidence the paper demonstrates that under weak conditions the unit root and cointegration structure of stock prices should mirror the unit root and cointegration structure of their dividend payments the paper tests this prediction by constructing national dividend series from capital international s dividend yield data as well as by using gnp data as with stock prices the evidence points to a single common trend although the stochastic properties and relative importance of this trend differs somewhat from the trend in stock prices

the persistence of the peso problem when policy is noisy abstract the peso problem the market s belief that a discrete event may occur has frequently been blamed for the persistence of on average mistaken forecasts of macroeconomic variables this paper demonstrates how beliefs that a policy process may have switched can induce apparent ex post biased forecasts of exchange rates even after the switch has occurred furthermore during this peso problem period exchange rates may appear to contain a speculative bubble component since they will systematically deviate from the levels implied by observing fundamentals ex post and the conditional variance of exchange rates will exceed the variance implied by observing fundamentals

learning and the volatility of exchange rates abstract this paper investigates the implications for the volatility of exchange rates of specifying market uncertainty as parameter uncertainty private agents learn by means of bayes rule about a parameter of the stochastic process generating the exogenous variables learning is shown to magnify the reaction of exchange rates to random shocks to the market fundamentals this magnification effect of learning can explain the rejections of the econometric tests on the variance bounds and on the absence of bubbles that have been reported in the literature

exchange rate and relative monetary expansions the case of simultaneous hyperinflation and rational expectations abstract the relationship between the exchange rate and relative monetary expansions of poland and germany in the 1920s when the countries are under simultaneous hyperinflation is studied the results show that for this period of predominantly monetary shocks the conventional specifications of the monetary model of exchange rate determination with rational expectations cannot be rejected the results therefore support the monetary approach in its most conducive environment

do asset demand functions optimize over the mean and variance of real returns a six currency test abstract international asset demands are functions of expected returns optimal portfolio theory tells us that the coefficients in this relationship depend on the variance covariance matrix of real returns but previous estimates of the optimal portfolio 1 assume expected returns constant and 2 are not set up to test the hypothesis of mean variance optimization we use maximum likelihood estimation to impose a constraint between the coefficients and the error variance covariance matrix for a portfolio of six currencies we are able statistically to reject the constraint evidently investors are either not sophisticated enough to maximize a function of the mean and variance of end of period wealth or else are too sophisticated to do so

accounting for exchange rate variability in present value models when the discount factor is near 1 a well known stylized fact about nominal exchange rates among low inflation advanced countries particularly u s exchange rates is that their logs are approximately random walks michael i mussa 1979 is most frequently cited for observing this regularity in a famous pair of papers richard a meese and kenneth rogoff 1983a b found that the structural models of the 1970 s could not beat a random walk in explaining exchange rate movements recently some authors menzie chinn and meese 1995 nelson mark 1995 mark and donggyu sul 2001 have argued that the models can outforecast the random walk at long horizons but a comprehensive recent study by yin wong cheung et al 2003 documents that no model consistently outperforms a random walk why one obvious explanation is that the macroeconomic variables that determine the exchange rate themselves follow random walks if the log of the nominal exchange rate is a linear function of forcing variables that are random walks then it will inherit the random walk property the problem with this explanation is that the economic fundamentals proposed in the most popular models of exchange rates do not in fact follow simple random walks one resolution to this problem is that there may be some other fundamentals ones that have been proposed in some models but are not easily measurable or ones that have not yet been proposed at all that are important in determining exchange rates if these unobserved fundamentals follow random walks and dominate the variation in exchange rate changes then exchange rates will nearly be random walks even if the standard observed fundamentals are not in engel and west 2003a hereinafter ew we propose an alternative explanation we consider linear models of the exchange rate that are in the asset market approach to exchange rates these models emphasize the role of expectations of future economic fundamentals in determining the current exchange rate the exchange rate expressed as the home currency price of foreign currency in this paper can be written as a discounted sum of the current and expected future fundamentals

the monetary approach to the exchange rate revisited 1984 the monetary approach to the exchange rate revisited applied economics vol 16 no 5 pp 771 782

the dollar pound exchange rate in the 1920s an empirical investigation much of the empirical support for the monetary approach to exchange rate determination has been obtained with data from the 1920s for example clements and frenkel 4 frenkel 8 9 frenkel and clements 11 and huang 18 all obtained favorable empirical evidence estimating different versions of the monetary model the empirical results with data from the 1970s however are mixed bilson 1 2 3 edwards 7 hoffman and schlagenhauf 16 and woo 25 obtained favorable empirical evidence while dornbusch 6 hartley 14 huang 17 meese and rogoff 20 and shafer and loopesko 24 obtained contrary empirical evidence this mixed performance of the monetary exchange rate model in the 1970s has been attributed by dornbusch 6 and frenkel 10 to the failure of purchasing power parity ppp to hold in the short run and by meese and rogoff 21 to the instability of the u s money demand function we re examine the empirical evidence on the dollar pound exchange rate in the 1920s using the simple monetary exchange rate model popularized by bilson 1 2 and frenkel 8 9 thus it is not the purpose of this paper to suggest new empirical monetary exchange rate models nevertheless there are several important reasons why we re examine the simple monetary exchange rate model first several important implications of the monetary exchange rate model in our opinion are not adequately tested in existing work second there is a presumption that the failure of the monetary exchange rate model in the 1970s and the 1980s is due to special events such as real shocks that affected ppp and the instability of the u s money demand function by using the data from the 1920s we hope to avoid the problem of the instability of the u s money demand equation in the 1970s moreover frenkel 10 found that ppp held up reasonably well in this period thus the period of the 1920s provides a favorable setting to test the monetary approach finally we choose the dollar pound exchange rate based on data availability our empirical methodology differs from most previous empirical studies in that we estimate the reduced form equation of the exchange rate within a system of three equations in addition to the reduced form equation of the exchange rate there are also two equations describing monetary equilibrium one for the domestic economy and one for the foreign economy the estimation

the monetary approach to exchange rate in an efficient foreign exchange market tests based on volatility the variance bounds on exchange rate movements implied by the monetary approach to exchange rate in an efficient foreign exchange market is shown to be violated by sample data the paper also presents evidence showing that the forecast errors implied by the monetary model can be forecasted using historical data the results are interpreted to suggest either the incompatibility of the monetary approach with sample data or an inefficient foreign exchange market or both models of exchange rate determination based on the monetary approach to the balance of payments imply when coupled with an interest rate parity relation and the assumption of an efficient foreign exchange market that exchange rates are related to a long average of money stocks differentials 1 2 the long average is analogous to the difference across countries of the long average of expected future money stocks which was supposed to characterize the price level of a single country see e g sargent and wallace 20 since long averages are known to have certain smoothing properties it appears that the observed volatility of exchange rates may be inconsistent with these models thus alternative tests of the models may be produced which rely on those properties the aim of this paper is to determine if the observed volatility is consistent with those properties the paper is the first to use tests based on the volatility of the exchange rate in an efficient market model of the monetary approach the first set of tests is based on the property of implied variance bounds for exchange rate movements and the second set consists of the more familiar efficient market tests of forecastability the empirical results violate these two sets of tests of the model thus casting doubt on the model even though the claim that exchange rates are too volatile has been commonly made few direct attempts have been made in the past to determine the validity of the claim some studies have presented estimates of variances of spot and forward rates but lacking an objective criterion to determine what constitutes

fundamentals uncertainty bubbles and exchange rate dynamics abstract using a monetary model of exchange rate determination we study exchange rate dynamics with bubbles which depend on stochastic market fundamentals these dynamics can be either stochastically stable or unstable and either monotonic or non monotonic including cyclic in an extreme case they converge with probability one and exhibit cyclic movements implications for the analysis of time dependent regime shifts are also explored exchange rates with bubbles are likely to appear less volatile than the fundamentals in finite samples both the variance bounds and cointegration tests might thus be ineffective in testing the absence of bubbles under fundamentals uncertainty

simulated likelihood estimation of diffusions with an application to exchange rate dynamics in incomplete markets abstract we present an econometric method for estimating the parameters of a diffusion model from discretely sampled data the estimator is transparent adaptive and inherits the asymptotic properties of the generally unattainable maximum likelihood estimator we use this method to estimate a new continuous time model of the joint dynamics of interest rates in two countries and the exchange rate between the two currencies the model allows financial markets to be incomplete and specifies the degree of incompleteness as a stochastic process our empirical results offer several new insights into the dynamics of exchange rates

testing the canonical model of exchange rates with unobservable fundamentals in this paper the authors test the asset market approach or canonical model of exchange rates they treat exchange rate fundamentals as unobservable the empirical results do not reject the canonical model and therefore the embedded rational expectations assumption in sharp contrast with previous empirical evidence the authors also find evidence of feedback from the exchange rate to fundamentals which is normally omitted in the theoretical literature copyright 1997 by economics department of the university of pennsylvania and the osaka university institute of social and economic research association