Testing for Purchasing Power Parity and Uncovered Interest Parity in the Presence of Monetary and Exchange Rate Regime Shifts

Abstract

Testing for purchasing power parity (PPP) and uncovered interest parity (UIP) has been the focus of many empirically oriented studies. Whilst these simple economic theories of exchange rate and interest rate determination are theoretically attractive, the empirical support for these equilibrium conditions is at best mixed. Many potential reasons have been cited in the literature for the failure of such studies, ranging from market imperfections to inappropriate modelling strategies. The current state-of-the-art procedure involves testing for two cointegrating vectors in a multivariate error correction model which may be economically identified as the PPP and UIP relations. However, such a procedure does not account for the policy regime shifts which often characterise economic time series. It is proposed that such regime shifts distort the underlying PPP and UIP relations, making them difficult to detect when modelled within this conventional framework. In this paper, a Markov-switching vector error correction model (VECM) is considered for time series data in which monetary and exchange rate regime shifts are known a priori to be present. Weak evidence in favour of PPP and UIP is established in a standard linear VECM, although the residuals of this model clearly indicate that it is inappropriate in terms of functional form. The Markov-switching VECM, however, provides convincing evidence in favour of both the PPP and UIP relations and a marked improvement in the residual distributions. An enlightening by-product of this method is the databased estimation of regimes which appear to conform to those suggested by economic history.

Further Evidence of Long Memory in the South African Stock Market

“…The Expected Maximization (EM) algorithm – which runs a number of iterations in order to estimate the Markov model's parameters (Lacerda, 2008) – was used to estimate the transitional probabilities between these regimes. However, since Hamilton's Markov model (1989) can only be used to model one time series at a time, Krolzig's (1997) Markov Switching Vector Autoregressive Model (MS‐VAR), in which multiple relationship analysis is possible, will be used.…”

“…The MS‐VAR model is an extended version of the standard VAR model which is defined as (Lacerda, 2008):…”

A Double-Edged Sword: High Interest Rates in Capital Control Regimes

“…We have already corrected for the risk premium, but the issue of transaction costs remains. 24 Regardless, the condition can serve as an equilibrium benchmark in the VECM, from which the economy deviates in the short run.Rewriting equation (12) and making the strong assumption of rational expectations yields: log( +1 ) − log( ) = * − + ε t (15) _________________________ 24 A possible way to account for transaction costs would be to allow for a constant in the interest parity relation, as in Lacerda et al (2010), which would account for systematic deviations in the short run.www.economics-ejournal.org 19 where ε t is a white noise term. A p-th order VECM in the variables in (15), taking the eurozone interest rate to be exogenous, is:…”

“…Rewriting equation (12) and making the strong assumption of rational expectations yields: log( +1 ) − log( ) = * − + ε t (15) _________________________ 24 A possible way to account for transaction costs would be to allow for a constant in the interest parity relation, as in Lacerda et al (2010), which would account for systematic deviations in the short run.…”

The dynamic response of the rand real exchange rate to fundamental shocks

“…The PPP condition refers to the convergence of prices of similar perfectly traded goods across borders (Chong et al, 2010). Empirical research finds that PPP generally holds in the long-run for South Africa (see Gupta et al, 2009;Lacerde et al, 2010;Sichei et al, 2005;Raputsoane and Todani, 2008;De Bruyn et al, 2012).…”