Discussion Papers In Economics
And Business

THREE ALTERNATIVE HYPOTHESES ON THE YEN–DOLLAR EXCHANGE
RATE OVER THE LAST 30 YEARS

Yuzo Honda and Hitoshi Inoue

Discussion Paper 15-15

Graduate School of Economics andOsaka School of International Public Policy (OSIPP)
Osaka University, Toyonaka, Osaka 560-0043, JAPANTHREE ALTERNATIVE HYPOTHESES ON THE YEN–DOLLAR EXCHANGE
RATE OVER THE LAST 30 YEARS

Yuzo Honda and Hitoshi Inoue

Discussion Paper 15-15

June 2015

Graduate School of Economics andOsaka School of International Public Policy (OSIPP)
Osaka University, Toyonaka, Osaka 560-0043, JAPANTHREE ALTERNATIVE HYPOTHESES ON THE YEN–DOLLAR EXCHANGE
RATE OVER THE LAST 30 YEARS ＊Yuzo Honda †Hitoshi Inoue ‡Abstract
We empirically investigate the dynamic nature of three alternative hypotheses on the foreignexchange rate between the Japanese yen and US dollar in a multivariate context, using datafrom April 1985 to October 2014. The three hypotheses are the uncovered interest rate parity
hypothesis, the current account hypothesis, and the quasi purchasing power parity hypothesis.
Each hypothesis has significant influence on the yen–dollar exchange rate. Furthermore, ittakes two to three years for the yield spread between the yen and dollar to have its largest
impact on the exchange rate. In addition, the effects of unexpected shocks to the exchange rateon the export price ratio and current account are long lasting.

Keywords: Quasi Purchasing Power Parity, Uncovered Interest Rate Parity, Soros Chart,
Monetary Policy, Vector Autoregression

JEL Classification Numbers: E52, F31＊

An earlier version of this paper was presented at a seminar at the Development Bank of Japan on March 6, 2015.
We sincerely thank the participants of the seminar for their helpful comments. We are also grateful to Eiji Ogawa
and Masahiko Shibamoto for valuable comments and useful suggestions.
†
Correspondence: Department of Informatics, Kansai University, 2-1-1, Ryozenji-cho, Takatsuki-shi, Osaka
569-1095, JAPAN‡
Faculty of Economics, Sapporo Gakuin University, 11-banchi Bunkyodai, Ebetsu, Hokkaido, 069-8555, JAPAN1

INTRODUCTION

The Japanese economy has been disrupted frequently, and sometimes damaged severely, by
fluctuations in foreign exchange rates, following adoption of a floating exchange rate system in
1971. It is important, therefore, to understand the properties of foreign exchange rates andmake use of this knowledge in policy making. In this paper, we examine the dynamic nature of
the yen–dollar exchange rate over the last 30 years. In particular, we address a simple question.
What determines the nominal yen–dollar exchange?
There are three prominent alternative hypotheses on exchange rate determination: (1) the
uncovered interest rate parity hypothesis (UIP), (2) the current account hypothesis (CA), and(3) the purchasing power parity hypothesis (PPP). Although there is extensive literature onthese hypotheses, most studies examined the validity of each hypothesis, ignoring the othercompeting hypotheses. Omitting other relevant variables introduces bias in estimation, andleads to inconsistent estimates. The present paper incorporates all three hypotheses into ourmodel simultaneously, and therefore avoids this type of criticism.
The reason all relevant variables should be incorporated into a model when making policy
decisions is illustrated by the following example. On December 14, 2010, Nihon Keizai
Shinbun featured an article by one of the present authors, arguing that bold expansionary
monetary policy by the US Federal Reserve was the cause of the rapid and extreme
appreciation of the Japanese yen relative to the US dollar. 1 He also suggested that the Bank ofJapan (BOJ) should conduct bold expansionary monetary policy to soften the impact offinancial shocks by the Federal Reserve on Japan’s real economy. Figure 1 was used as
evidence, where the data point in the middle of the figure is for October 2008, the data points to1

Hamada et al. (2010, pp. 34–38) report that it was the late Mr. Okada Yasushi at the Cabinet Office at that time
who first produced the three comparative charts on the size of central banks’ balance sheets, real effective
exchange rates, and industrial production for Japan, the US, the euro area, and the UK.

1the northeast are prior to October 2008, and those to the southwest are posterior to October
2008. 2 Figure 1 shows a clear positive correlation between the base money ratio and theexchange rate. The correlation between the base money ratio and the foreign exchange rate iscommonly known among investors as the “Soros Chart (SC).”The day after the publication of this article, the author received an email from a BOJ
economist, including five other charts using different sample periods, along with Figure 1, toshow that there was little correlation between the yen–dollar exchange rate and the base money
ratio.
In general, Figure 1 is not sufficient to prove a causal relationship from the base money
ratio to the exchange rate; first, because it only shows a correlation, and second, because otherrelevant variables exist that may affect both the base money ratio and the exchange rate.
Despite this counterargument, we still argue that the sharp appreciation of the Japanese yen in
Figure 1 is the result of bold expansionary monetary policy by the US Federal Reserve. The
action undertaken by the Federal Reserve at that time was so extreme in magnitude that it
dominated all other relevant variables. In other time periods, other variables have affected theexchange rate, which is the reason we do not observe the correlation in the other five charts.
The bold action by the Federal Reserve after the bankruptcy of Lehman Brothers was a kind of“natural experiment.” To substantiate our arguments above, we employ a vector autoregression(VAR) to control for other relevant variables in the determination of the yen–dollar exchange
rate.

[Figure 1 around here]

2

Recall that Lehman Brothers went bankrupt in September 2008.

2

Furthermore, we empirically demonstrate that it takes two to three years for monetary
policy shocks to have their largest impact on the yen–dollar exchange rate. At first, this result issurprising because there is an arbitrage relationship between the exchange rate and interest rate
differential between yen and dollars. We might expect that the exchange rate would respond
most significantly immediately after a monetary policy shock. However, this is not the case.
We will explain why in Section 6.
The outline of this paper is as follows. In Section 2, we explain the three alternative
hypotheses of exchange rate determination. In Section 3, we present our baseline monthly
model. To complement our baseline model, Section 4 estimates the corresponding quarterly
model with a lag length of one year to examine the effects of longer lags on the exchange rate.
In Section 5, we check the stability of the parameters of our models. Section 6 discusses somepolicy implications of our estimates. Section 7 summarizes our findings and the limitations of
our study.

2

THREE ALTERNATIVE HYPOTHESESIn this section, we discuss the three alternative hypotheses of exchange rate determination,
namely, UIP, CA, and PPP. We also explain SC, a variant of UIP.

2.1 Uncovered Interest Rate Parity Hypothesis
There are two distinct kinds of behavior related to UIP, the behavior of market investors andthat of central banks.

2.1.1 Behavior of Market Investors
In the short run, arbitrage operates between Japanese and US government bonds. Investors inbond markets seek profits by changing portfolio allocation, and in equilibrium, the following
3

arbitrage relationship should hold:𝑒𝑒 ∗r ∗ − r ≈ 1 − � 𝑒𝑒 �,(1)where r, r ∗ , e, and e∗ denote returns from Japanese government bonds, returns from US

government bonds, the foreign exchange rate, and the expected foreign exchange rate at theend of the period, respectively. This hypothesis is known as UIP. The symbol ≈ indicates“nearly equal.” Arbitrage is the main force affecting the exchange rate. Many studies havetested whether UIP holds (see, for example, Ito (2005)). As this is an arbitrage relationship,

causality operates both ways between the exchange rate e, the expected exchange rate e∗ , andthe yield spread between US and Japanese government bonds, r ∗ − r.
2.1.2 Behavior of Central Banks

The injection of base money lowers the interest rate in the two-asset model, as in the textbook
IS–LM model. In slightly more complicated models with more than two assets, it is easy toshow that the injection of base money lowers the value of the domestic currency. The economic
reason for this conclusion is that the domestic currency and a foreign currency are imperfect
substitutes in the portfolio choices of capital investors, and the additional supply of thedomestic currency lowers its value relative to a foreign currency.
In normal economic conditions with positive short-term interest rates, central banks control
the short-term interest rate. Lowering (raising) the short-term interest rate is equivalent to an
injection (retraction) of base money to financial markets by the central bank. Hence, theFederal Reserve and BOJ have the power to influence the return on US and Japanese
government bonds, r ∗ and r. When the Japanese and US monetary authorities affect r ∗ − r on

the left-hand side of equation (1), this should also affect the current exchange rate e on the4right-hand side. 3
As for monetary policy effects, causality only operates in one direction. Changes inmonetary policy in the US or Japan affect the foreign exchange rate, but not vice versa.
However, if the monetary authorities should react to changes in the foreign exchange rate,causality in the opposite direction may occur.

2.2 Current Account Hypothesis
Trade imbalances were one of the central economic issues between Japan and US in the 1980s.
The resulting huge surpluses in Japan’s current account increased the supply of US dollars in
the foreign exchange market, and lowered the value of the US dollar relative to the Japaneseyen. This is known as the CA hypothesis.
Honda(p.6, 1995) plots the yen-dollar exchange rate on the vertical axis against theJapanese current account (measured in dollars) on the horizontal axis to find both a trend(toward an appreciation of the yen) and cycles around the trend at least up until early 1990s. In
terms of the cycles, increases in Japan’s current account surplus appear to lead to appreciationsof the yen relative to dollars.

2.3 Purchasing Power Parity Hypothesis
PPP argues that arbitrage occurs with the prices of goods and services, and that purchasing
power across currencies should be the same. In symbols,
P = P ∗ e,(2)

3

Changes in r*-r on the left-hand side of equation (1) might also affect the expected exchange rate e*on theright-hand side. However, reliable data on e* is not available in reality, and we did not include a proxy for e*in ourempirical models. Should there be reliable data for e* available, its inclusion into our models would certainly bedesirable.

5where P and P* denote the Japanese and US general price levels, respectively.
UIP results from arbitrage behavior among portfolio investors in bond and capital markets.
PPP, on the other hand, results from arbitrage purchasing behavior by people in terms of
tradable goods and service. People purchase goods and services in the country where thesegoods and services are cheaper. In equilibrium, the prices of these tradable goods and services
should be the same across the two countries under certain conditions. The effects of arbitrage
behavior on tradable goods and services will be transmitted eventually to the prices of
nontradable goods and services as well, and thus equation (2) should hold in the long run.
Again, many papers examine this hypothesis (see, for example, Royal Swedish Academy of
Sciences (2003), and Hayashi (2000)).
In this paper, we are interested mainly in the behavior of the yen–dollar exchange rate. Thatis, we are interested in which factors affect the foreign exchange rate most. We expect that
arbitrage is stronger for export prices than for general prices in equation (2). Hence, we use
export price indexes for P and P* instead of general price indexes. This is why we refer to the
hypothesis here as the quasi purchasing power parity (quasi PPP) hypothesis instead of PPP.

2.4 The Soros Chart
The well-known investor, George Soros, is said to have taken advantage of the correlation
between base money ratios and exchange rates in his portfolio decisions; the chart showing thiscorrelation is now known among investors as the “Soros Chart.”
SC can be considered a variant of UIP. Under normal economic conditions with positive
short-term interest rates, changes in base money can be considered equivalent to changes inshort-term interest rates. This equivalence, however, does not hold with zero short-term interest
rates. Yet even under the condition of zero short-term interest rates, investors still have a choice
between intermediate- and long-term Japanese bonds and the US counterpart. Then, in
6equilibrium, arbitrage might still operate in the intermediate- to long-term bond markets. Thisis one possible explanation of SC.
An alternative possible explanation for SC is that the quantity of base money represents themonetary policy stance of central banks. In this interpretation, the base money ratio indicatesthe respective monetary policy stances of the Federal Reserve and/or the BOJ. An increase inbase money by the Federal Reserve (or the BOJ), for example, leads to an increase in moneystock in the US (or Japan) through money creation process, as time goes by, which in turndecreases the value of US dollars (or Japanese yen) in the future. This line of expectations
should change the current exchange rate now toward the depreciation of the US dollar (orJapanese yen). Note that causality operates in one direction under this interpretation from thebase money ratio to the exchange rate.

3

SIX-VARIABLE MODELS IN THE SHORT RUN

In this section, we use structural vector autoregressions (VAR) as our short-run baselinemonthly model. The model consists of six variables:
Y ′ = (cpi, iip, epr, ca, spread, e),(3)where cpi, iip, epr, ca, spread, and e denote respectively: consumer price index; index ofindustrial production; export price ratio, or the ratio of the Japanese export price index to thatof the US; Japanese current account measured in Japanese yen; yield spread between US andJapanese 2-year government bonds; and the yen–dollar exchange rate (measured as yen per
dollar). All variables are in levels. 4 We include variables cpi and iip in our baseline model tocontrol for the effects of the macroeconomy. Our sample covers the period from April 1985 to4

Regarding using variables in levels, Hamilton (1994, p. 652) notes: “(1) The parameters that describe thesystem’s dynamics are estimated consistently. (2) Even if the true model is a VAR in differences, certain functionsof the parameters and hypothesis tests based on a VAR in levels have the same asymptotic distribution as would
estimates based on differenced data. (3) A Bayesian motivation can be given for the usual t or F distributions fortest statistics even when the classical asymptotic theory for these statistics is nonstandard.”

7

October 2014, and the number of observations is 355. We use Schwarz’s Bayesian Information
Criterion (SBIC) to choose a lag length of three months in the VAR. To identify the structuralparameters, we employ a recursive structural model with a Cholesky decomposition. We orderthose variables with stronger exogeneity first, following the suggestion of Sims(1980), as canbe seen in equation (3). We use a one standard deviation shock of each variable in the impulse
response analysis.
Considering SC as a variant of UIP, we replace the yield spread variable with the basemoney ratio (bmr hereafter; the ratio of Japanese base money to US base money) in equation(3) when we examine the validity of SC. Next, we report the estimated results for the baselinemonthly model, and the case of SC.

3.1 Responses of the Yen–Dollar Exchange Rate
Figure 2 shows the impulse response estimates of the yen–dollar exchange rate to various
shocks. The solid lines indicate the point estimates, and the bands are the 95% confidence
intervals, which are calculated using a bootstrap simulation with 400 repetitions. The
horizontal axis measures months after a given shock.
Panel (1,3) in Figure 2 suggests that a positive shock to Japanese export prices, given US
export prices, reduces the supply of US dollars in the foreign exchange market. This in turnincreases the value of the US dollars, and the yen depreciates. Panel (2,1) in Figure 2 showsthat a positive shock to the current account appreciates the yen relative to the dollar
significantly. Panel (2,2) in Figure 2 shows that a positive shock to the yield spread, r ∗ − r, (forexample, a more expansionary monetary policy by the Federal Reserve, relative to that by theBOJ), appreciates the yen relative to the dollar at the 5% significance level. The peak of the
impact turns out to occur 20 months after the initial shock. We discuss this point in Section 6 inmore detail.
8[Figure 2 around here]

Table 1 shows the corresponding results of Granger causality tests on the yen–dollar
exchange rate. The export price ratio (epr), current account (ca), and yield spread (spread) are
all found to Granger-cause the yen–dollar exchange rate at the 1% level.

[Table 1 around here]

We also examine the variance decompositions of the effects of the abovementioned threevariables on the yen–dollar exchange rate and find similar results. Therefore, the impulse
response functions, variance decompositions, and Granger causality tests all indicate that theexport price ratio, current account, and yield spread all have significant impacts on the yen–dollar exchange rate.

3.2 Impacts of the Yen–Dollar Exchange Rate
We examine the effects in the opposite direction, and report the possible impacts of changes inthe yen–dollar exchange rate on export price ratio, current account, and yield spread.
Figure 3 reports the responses of the above three variables to a positive shock (ordepreciation) in the yen–dollar exchange rate. Figure 3(1) indicates that a positive shock in the
yen relative to the dollar leads to a reduction in Japanese export prices relative to US export
prices. As shown, the impacts are significant but with long time lags. This dynamic effect froma yen depreciation to a reduction in export prices, and thus to increases in exports with sometime delay, is known as the “J curve” effect.
Figure 3(2) shows that a positive shock in the yen relative to the dollar has little effect on
9the current account. However, the lag length of our baseline monthly model is only threemonths. We suspect that a three-month lag length might be too short to capture the full impactof a change in the exchange rate on the current account. In Section 4, we report different resultsfrom a modified model with longer lag lengths.
Figure 3(3) indicates a yen depreciation (appreciation) shock leads to a decrease (anincrease) in the yield spread. This dynamic pattern might reflect Japanese government
intervention in the foreign exchange market in the past to curb the sharp appreciation of the yen
relative to the dollar (see, for example, Takagi (2015)).

[Figure 3 around here]

Granger causality tests of the relationships in Figure 3 are reported in Table 2. These results
support the impulse response analysis in Figure 3, and confirm the validity of the above
interpretation.

[Table 2 around here]

In summary, the exchange rate has significant impacts on the export price ratio and yieldspread, but not on the current account in our baseline monthly model. However, the finding forthe current account may be due to misspecification of the lag length; we examine thispossibility in Section 4.

3.3 The Soros Chart
Figure 4(1) shows that a positive shock to Japanese base money relative to US base money
10

leads to a depreciation of the yen at the 5% significance level. Figure 4(2) shows the impulse
response estimates for the base money ratio to a positive shock in the yen–dollar exchange rate.
One possible reason for the result in Figure 4(2) is that the Japanese government has intervenedin the foreign exchange market in the past, and purchased US dollars to curb the sharp
appreciation of yen. However, the significance of these effects can be questioned because theconfidence bands cover the entire horizontal axis.

[Figure 4 around here]

Table 3 shows the results of Granger causality tests corresponding to Figure 4. Taken
together, Table 3 and Figure 4 suggest that the base money ratio affects the yen–dollar
exchange rate, but not vice versa.

[Table 3 around here]

Furthermore, comparing the effects of the yield spread on the exchange rate in panel (2,2)
of Figure 2 and the counterpart for the base money ratio in Figure 4(1), we find that the former
is clearly significant at the 5% level, while the latter is only marginally significant. This mightsuggest that the arbitrage relationship between the exchange rate and yield spread is stronger
than that between the exchange rate and base money ratio.

3.4 Robustness
Our results in the above are robust to changes in the order of variables. We tried more than ten
cases of different order of variables to find little change in our impulse response estimates.

11

4

QUARTERLY MODELS WITH ONE-YEAR LAGS

As with the J curve effect, it might take a long time for some shocks to have their full impact.
To deal with this issue, we report the estimated results of another model with longer lag
lengths. More specifically, we consider quarterly models, using the same sample period. In thiscase, the SBIC suggests using three lags. However, the estimates from models with three lags
are very similar to those from models with four lags covering 12 months. If we put one-year
lagged variables on the right-hand side, we expect these lagged variables to control any
seasonality effects. Consequently, we report here the estimation results from a model with lags
covering 12 months. As for the control variables, we replace cpi and iip in the monthly models
with GDP deflator (def) and real GDP (rgdp) in the quarterly models, respectively.

4.1 The Quarterly Model Corresponding to the Baseline Monthly Model
Figure 5 shows the impulse response estimates of the yen–dollar exchange rate to various
shocks. Figure 6 depicts the impulse responses of the export price ratio, current account, andyield spread to a depreciation shock in the yen–dollar exchange rate. The measure on thehorizontal axis in Figures 5, 6, and 7 is quarters after a given shock. Tables 4 and 5 report theresults of the Granger causality tests, corresponding to Figures 5 and 6.

[Figures 5 and 6 around here][Tables 4 and 5 around here]

Comparing these with the corresponding results from the baseline monthly model, weobserve the following three points. First, overall, the results in the quarterly model are very
similar to those in the baseline monthly model. Second, although we find that the yen–dollar
exchange rate does not Granger-cause the current account in our baseline monthly model in12

Table 2 (p-value of variable ca is 0.542), the yen–dollar exchange rate does Granger-cause thecurrent account at the 10% significance level in our quarterly model in Table 5 (p-value ofvariable ca is 0.088). We also observe similar results from the impulse response analyses. Thatis, the time periods in which the confidence bands do not contain the horizontal line in ourquarterly model in panel (2,1) of Figure 5 are much longer than the counterparts in our baselinemonthly model in panel (2,1) of Figure 2. The main difference between the baseline monthly
model and the quarterly model is that the former has a three-month lag length, while the latterhas a 12-month lag length. These findings suggest that changes in the exchange rate affect thecurrent account, but with a longer lag. Third, it takes as long as almost three years for the yieldspread to have its largest impact on the yen–dollar exchange rate in our quarterly model inpanel (2,2) of Figure 5. The corresponding time period in our baseline monthly model in panel(2,2) of Figure 2 is almost two years. Thus, we conclude that it takes two to three years for theyield spread to have its largest impact on the exchange rate.

4.2 The Soros Chart in the Quarterly Model
Figure 7(1) reports the impulse responses of the yen–dollar exchange rate to a positive shock inthe base money ratio in the quarterly model. Figure 7(1) indicates that an increase in theJapanese base money relative to the US leads to a depreciation of the yen at the 5% significancelevel. The peak of the impact is about two years after the shock. Although the estimates of the
impact are only marginally significant in the baseline monthly model in Figure 4(1), they areclearly significant at the 5% level in the quarterly model with longer time lags in Figure 7(1).

[Figure 7 around here]

Figure 7(2) shows the impulse responses of the base money ratio to a depreciation shock in13

the exchange rate in the quarterly model. The estimates are not significant at the 5% level.
Table 6 shows the results of the Granger causality tests corresponding to Figure 7. These results
together with Figure 7 suggest that the base money ratio affects the yen–dollar exchange rate,
but not vice versa.

[Table 6 around here]

5

POSSIBLE STRUCTURAL CHANGES IN PARAMETERS

We now examine the possibility that the parameters in our VAR might have changed over the
sample period. To check this possibility, we add another variable to each one, including theintercepts, in the right-hand side of our VAR system. The added variable is the original one
multiplied by a dummy variable, which has a value of zero before a possible structural change
period and one after that. Under the null hypothesis of no structural change in parameters, thecoefficients of all added variables are zero. Under the alternative hypothesis, at least one of thecoefficients are nonzero. We calculate the likelihood ratio test statistics, and repeat the sameprocedure at different points in time. The results are presented in Figure 8, where time ismeasured on the horizontal axis and the values of the test statistics are given on the verticalaxis. Figure 8 indicates that the parameters are most likely to have changed just after March
1989. Hence, we reconducted the above analysis for our baseline monthly model using data
only for the period from April 1989 onward. However, there was little difference in ourestimates from the baseline monthly model with 355 observations and the model with thesmaller sample of 307 observations.

[Figure 8 around here]14

If we confine ourselves to the more recent years in Figure 8, we find that the test statistic ishighest just after January 2006. Again, we reconducted the above analysis using our baselinemonthly model, using data only from February 2006 onward. We found that the point estimatesfrom the smaller sample had the same qualitative properties as those from our baseline monthly
model, but that the confidence bands were much wider using the smaller samples. Therefore,
we found less statistical significance for all variables, including the export price ratio, current
account, and yield spread with the smaller samples of 105 observations.

6

SOME POLICY IMPLICATIONS

Next, we discuss our empirical results from the viewpoint of monetary policy.

6.1 UIP and Monetary Policy
It is important to distinguish between two kinds of effects when short-term interest rates (orbase money ratio in the case of SC) change. One is the effects of portfolio behavior by market
investors in financial markets. These effects are immediate, as arbitrage occurs immediately.
Here, we call these “portfolio effects.”
The second type of effects is caused by the interaction between financial variables andmacroeconomic variables. We call these interactive effects of monetary policy“macroeconomic effects.” It usually takes a few years for monetary policy shocks to betransmitted to the real sector and to have their full impact on the macroeconomy.
When the monetary authorities change their short-term interest rate (or the quantity of basemoney in the case of SC), the exchange rate reacts to this shock immediately (the first type ofeffects). However, the impulse response results in Figures 2, 5, and 7 suggest that the effects on
the exchange rate are long lasting, and that it takes two to three years for the effects of the15

impact to reach their peak. 5 Why does it take so long?
Our interpretation is as follows. When a new monetary policy shock occurs, it usually takes
a few years for the shock to have its full impact on the money supply through money creation
process. The money supply balances of yen relative to dollars are in turn the dominant
determinants of the yen–dollar exchange rate. Therefore, it takes two to three years for a newpolicy shock to have its full impact on the exchange rate.

6.2 Effects of an Exogenous Yen–Dollar Exchange Rate ShockAn exogenous unexpected shock to the foreign exchange rate (for example, an exogenouschange in the US money supply) has long-lasting effects on the export price ratio, current
account, and yield spread, as indicated by the impulse response results in Figures 3 and 6. In
particular, the impact of a shock to the yen–dollar exchange rate on the export price ratio lasts
more than five years, and on the current account almost permanently, as shown in Figure 6.

7

CONCLUDING REMARKSWe summarize our findings and discuss the limitations of the present paper. There are fourmain points. First, our empirical analyses support each of the three alternative hypotheses, UIP,
CA, and quasi PPP. Second, changes in the yen–dollar exchange rate have long-lasting impacts
on export prices and the current account, lasting more than five years. Third, monetary policy
has its largest impact on the exchange rate with a lag of two to three years. As for the Soros
Chart, we observe causality from the base money ratio to the yen–dollar exchange rate, but notvice versa.
In this paper, we concentrated our analysis on the main determinants of the yen–dollar

5This empirical result is robust to changes in the maturities of bonds. We tried bonds with maturities of two, three,and five years and found virtually the same results.

16exchange rate and on the impacts of changes in the exchange rate. To control for the effects toand from the real sector, we incorporated cpi and iip in our baseline monthly model, and GDP
deflator and real GDP in our quarterly model, respectively, for the sake of simplicity. However,to analyze fully the interaction between the exchange rate and the real sector, we need a moreelaborate specification for the real sector. This is beyond the scope of the current paper, andremains for future research.

17

DATA APPENDIX

Variable
cpi

Description

SourceConsumer price index (all items)

Statistics Japan

2010 average = 100
iip

epr

Index of industrial production (original index)

Ministry of Economy, Trade2010 average = 100

and Industry

Ratio of Japanese export price index (yen basis, all Bank of Japan
commodities) to that of the US (all commodities),

U.S. Department of Labor

both standardized at 1990ca

Current account (net balance)

Ministry of Finance Japan

spreadYield spread between US Treasury securities andMinistry of Finance Japan

Japanese government bonds (monthly average)

Board of Governors of theFederal Reserve Systeme

US dollar/yen spot rate at 17:00 in JST (average in Bank of Japanthe month, Tokyo market)

bmr

Ratio of Japanese base money (average amounts

Bank of Japan

outstanding) to US base money (total)

Board of Governors of theFederal Reserve Systemdef

GDP deflator (original series, 2005 = 100)

Cabinet OfficergdpReal GDP (original series, 2005 = 100)

Cabinet Office18

REFERENCES

Hamada, K., Wakatabe, M. and Katsuma, K. (2010). Learn from the Legendary Professor,
Toyokeizai Shinposha Publishing Co. (in Japanese).
Hamilton, J. (1994). Time Series Analysis, Princeton University Press.
Hayashi, F. (2000). Econometrics, Princeton University Press.
Honda, Y. (1995). ‘Japanese Economy under Deflation’, Business Cycles in Japan, (ed. Honda,
Y.), Yuuhikaku Publishing Co., pp. 1–20 (in Japanese).
Ito, T. (2005). ‘The Exchange Rate in the Japanese Economy: The Past, Puzzles, andProspects’, The Japanese Economic Review, Vol. 56, No. 1, pp. 1–38.
Takagi, S. (2015). Conquering the Fear of Freedom: Japanese Exchange Rate Policy since1945, Oxford University Press.
Royal Swedish Academy of Sciences (2003). ‘Time Series Econometrics: Cointegration andAutoregressive Conditional Heteroskedasticity’, Advanced Information on the Bank ofSweden Prize in Economic Sciences in Memory of Alfred Nobel, 8 October.
Sims, C. (1980). ‘Macroeconomics and Reality’, Econometrica, Vol.48, pp.1-48.

19

TABLESTABLE 1GRANGER CAUSALITY TESTS ON THE YEN–DOLLAR EXCHANGE RATE

20

TABLE 2
GRANGER CAUSALITY TESTS ON EXPORT PRICE RATIO, CURRENT ACCOUNT, AND YIELDSPREAD TO A POSITIVE SHOCK IN THE YEN–DOLLAR EXCHANGE RATE

21

TABLE 3
GRANGER CAUSALITY TESTS ON THE SOROS CHART IN THE BASELINE MONTHLY MODEL

22

TABLE 4
GRANGER CAUSALITY TESTS ON THE YEN–DOLLAR EXCHANGE RATE IN THE QUARTERLY
MODEL

23

TABLE 5
GRANGER CAUSALITY TESTS ON EXPORT PRICE RATIO, CURRENT ACCOUNT, AND YIELDSPREAD TO A POSITIVE SHOCK IN THE YEN–DOLLAR EXCHANGE RATE IN THE QUARTERLY
MODEL

24

TABLE 6
GRANGER CAUSALITY TESTS ON THE SOROS CHART IN THE QUARTERLY MODEL

25

FIGURES

FIG. 1. Base Money Ratio and Exchange Rate

January 2007 to December 2010
130
120

Exchange Rate (Yen/$)

110
100
90
80
70
0.4

0.6

0.8

1

Base Money in Japan/Base Money in US

26

1.2

FIG. 2. Impulse Responses for the Yen–Dollar Exchange Rate in the Baseline Monthly Model

27

FIG. 3. Impulse Responses for Yield Spread, Current Account, and Export Price Ratio to a Positive Shock(Depreciation) in the Yen–Dollar Exchange Rate in the Baseline Monthly Model

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FIG. 4. Impulse Response Estimates for the Soros Chart in the Baseline Monthly Model

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FIG. 5. Impulse Response Estimates for the Yen–Dollar Exchange Rate to Shocks in Export Price Ratio, Current
Account, and Yield Spread in the Quarterly Model

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FIG. 6. Impulse Response Estimates for Export Price Ratio, Current Account, and Yield Spread to a Depreciation
Shock in the Yen–Dollar Exchange Rate in the Quarterly Model

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FIG. 7. Impulse Response Estimates for the Soros Chart in the Quarterly Model

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FIG. 8. Likelihood Ratio Test Statistics for Possible Structural Breaks

33