Table Of ContentINTERNATIONAL PARITY CONDITIONS
International Parity
Conditions
Theory, Econometric Testing and
Empirical Evidence
Imad A. Moosa
Senior Lecturer in Economics
La Trobe University
Australia
and
Razzaque H. Bhatti
Assistant Professor of Economics
University ofA zad Jammu and Kashmir
Pakistan
First published in Great Britain 1997 by
MACMILLAN PRESS LTD
HoundmilIs, Basingstoke, Hampshire RG21 6XS and London
Companies and representatives throughout the world
A catalogue record for this book is available from the British Library.
ISBN 978-1-349-25525-2 ISBN 978-1-349-25523-8 (eBook)
DOI 10.1007/978-1-349-25523-8
First published in the United States of America 1997 by
ST. MARTIN'S PRESS, INC.,
Scholarly and Reference Division,
175 Fifth Avenue, New York, N.Y. 10010
ISBN 978-0-312-17262-6
Library of Congress Cataloging-in-Publication Data
Moosa, Imad A.
International parity conditions: theory, econometric testing and
empirical evidence / Imad A. Moosa and Razzaque H. Bhatti.
p. cm.
Includes bibliographical references and index.
ISBN 978-0-312-17262-6
I. Foreign exchange-Mathematical models. 2. Purchasing power
parity-Mathematical models. 3. Interest-Mathematical models.
4. International economic relations-Mathematical models.
I. Bhatti, Razzaque H., 1956- . II. Title.
HG3823.M664 1997
332.4'5-dc21 96-44007
CIP
© Imad A. Moosa and Razzaque H. Bhatti 1997
Softcover reprint of the hardcover 1s t edition 1997
All rights reserved. No reproduction, copy or transmission of this publication may be made
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Any person who does any unauthorised act in relation to this publication may be liable to
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The authors have asserted their rights to be identified as the authors of this work in
accordance with the Copyright, Designs and Patents Act 1988.
This book is printed on paper suitable for recycling and made from fully managed and
sustained forest sources.
10 9 8 7 6 5 4 3 2 I
06 05 04 03 02 01 00 99 98 97
To our Families
Contents
List of Figures xii
List of Tables xiv
Preface xv
1 Introduction 1
An Overview
The Resurgence of Interest in International
~~~ili~M 4
A Look at the Figures 5
What Follows in this Book 14
2 The Purchasing Power Parity Hypothesis 25
Introduction 25
Absolute and Relative PPP 27
PPP in the History of Economic Thought 30
The Arbitrage. Monetary and Asset Market Views of PPP 32
Ex Ante PPP 36
The Productivity Bias Hypothesis 38
PPP as a Long-Run Equilibrium Condition 39
Proportionality. Symmetry and Exclusiveness 42
The Effect of Different Weights. Non-Traded
Goods and Transportation Costs 44
Misinterpretation of Cassel 47
3 The Covered Interest Parity Hypothesis 53
Introduction 53
The CIP Hypothesis: A Formal Exposition 55
The Role of Transaction Costs 58
Less Than Infinite Elasticities 63
Capital Market Imperfections 65
Political Risk 67
Capital Controls 68
Data Imperfections 69
The Role of Speculation 69
The Effect of Taxes 72
Default Risk 73
VII
viii Contents
Fisherian Expectations 74
The Role of Uncertainty 75
The Role of News 76
4 Uncovered Interest Parity and the Efficient Market
Hypothesis 77
Introduction 77
The UIP Hypothesis 78
The Simple Efficiency Hypothesis 79
The General Efficiency Hypothesis 81
Rationalising the Failure of Unbiased Efficiency 82
Some Sources of Bias 89
5 Real Interest Parity and the Fisher Hypothesis 94
Introduction 94
The RIP Hypothesis 95
The Stability of the Fisher Closed Condition 97
Measurement of the Expected Inflation Rate 98
Allowing for Other Factors 101
The Choice of Interest Rate 103
Overlapping vs Non-Overlapping Data 104
The Choice of the Price Index 105
6 International Parity Conditions in a Cointegration
Framework 107
The Basic Idea 107
Historical Review and the Building Blocks 113
Statistical Background 118
The Random Walk Model 119
Stationarity 121
Deterministic and Stochastic Trends 122
Short-Memory and Long-Memory Series 132
The Order of Integration 133
Cointegrated Variables 134
Implications for Conventional Econometric Techniques 139
Cointegration Analysis: The Pros and Cons 139
7 Testing for Stationarity and Unit Root 143
Introduction 143
The Dickey-Fuller Test 144
The Phillips-Perron Test 148
Contents
IX
The Sims Bayesian Test 151
The Variance Ratio (VR) Test 152
Testing for Seasonal Unit Roots 158
Testing for Unit Root: Further Remarks 165
8 Cointegration: Representation and Testing 167
More about the Cointegrating Regression 167
Testing for Cointegration: Residual-Based Tests 170
The Johansen Multivariate Method 174
Other Tests for Cointegration 179
Granger's Representation Theorem 181
Seasonal Cointegration and Error Correction Models 184
Cointegration in a Time-Varying Parameter Framework 186
Cointegration and Causality 187
Cointegration and Exogeneity 189
Cointegration and Simultaneous Equation Models 190
Cointegration and Non-Linearities 191
Cointegration and Dynamic Specification 192
Model Building with Integrated Variables: Summary 193
9 Purchasing Power Parity: Model Specification
and Related Econometric Issues 195
Static Specifications 195
Dynamic Specifications 19S
The Direction of Normalisation 202
Short-Run vs Long-Run Specifications 204
Structural Changes and Time-Varying Parameters 205
Allowing for Uncertainty 206
Testing PPP in Conjunction with UIP 208
Confusion between Absolute and Relative PPP 208
10 Purchasing Power Parity: The Empirical Evidence 213
Evidence from the Flexible Exchange Rates of the 1920s 213
Evidence from the post-Bretton Woods Flexible
Exchange Rates 216
Exchange Rates of the EMS and Other European
Countries 226
Other Exchange Rates 228
Long-Run Data 230
Testing the Augmented PPP 234
Concluding Remarks 236
x Contents
11 Covered Interest Parity: The Empirical Evidence 239
The Efficient Market Test 239
The Conventional Regression Test 239
Cointegration Analysis 241
The Dynamic Modelling Approach 242
National Currency vs Eurocurrency Assets 243
An Overview of the Empirical Evidence 244
Concluding Remarks 250
12 Uncovered Interest Parity and the Efficient Market
Hypothesis: The Empirical Evidence 252
Conventional Regression Analysis 252
Error Orthogonality Tests 253
Tests Based on Vector Autoregression Analysis 254
Cointegration Analysis 254
Empirical Evidence on Nominal Interest Linkages 255
Empirical Evidence on Unbiased Efficiency:
The Flexible Exchange Rates of the 1920s 257
Empirical Evidence on Unbiased Efficiency:
The Testing Techniques 259
Empirical Evidence on Unbiased Efficiency:
Other Aspects 270
Concluding Remarks 278
13 Real Interest Parity and the Fisher Hypothesis:
The Empirical Evidence 280
Testing the FH: Conventional Regression Analysis 280
Testing the FH: Time-Varying Parametric Regression 284
Testing the FH: Serial Correlation and Orthogonality 285
Testing the FH: Cointegration Analysis 288
Testing the FH: Allowing for Controls and Taxes on
Interest Income 291
Testing the FH: Allowing for the Phillips and
Friedman Effects 293
Testing the FH: Final Remarks 294
Testing RIP: Conventional Regression Analysis 295
Testing RIP: Orthogonality Tests 298
Testing RIP: Cointegration Analysis 299
Testing RIP: Vector Autoregression Analysis 300
Testing RIP: The Kalman Filter Technique 301
Summary and Concluding Remarks 302
Contents xi
14 Concluding Remarks 304
Recapitulation 304
The Feldstein-Horioka Puzzle 306
Misconceptions about PPP 307
Where Do We Go From Here? 308
Notes 309
References 326
Author Index 360
Subject Index 367
