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7/28/2019 Mean Reversion in Long-horizon Real Exchange Rates
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MEAN REVERSION IN LONG-HORIZON REAL EXCHANGE RATES:
EVIDENCE FROM LATIN AMERICA by Pablo Astorga
Institut Barcelona de Estudis Internacionals (IBEI), Spain
Student:
Cristina Serac
Course name:
Development Macroeconomics
Lecturer:
António Portugal Duarte
2012-2013
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CONCEPTS
What is it “mean reversion” ?Mean reversion is the theory that interest rates, security prices, or various economic indicators will, over time, returnto their long-term averages after a significant short-termmove.
Half-life = measure of the speed of mean reversion andrefers to the number of years that it takes for deviations fromequilibrium to subside permanently below 0.5 in response toa unit shock in the level of the series.
The real exchange-rate puzzles is a common term fortwo much-discussed anomalies of real exchange rates: thatreal exchange rates are more volatile and show more persistence than what most models can account for. 2
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In the past, Rogoff’s puzzle illustrated mean reversion in long-term horizon with a half-life average of 3-5 years .
The new research approach reduces the mean reversion’s half -life average at 1,5 years.
How it is analysed the current study?
Are chosen the economies of Latin America countries (LA6): Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela Period studied: XXth century Steps:
1. Use a unit-root approach (structural breaks and trend behaviour) gives the possibility to compare the results
with other studies that examine the PPP hypothesis withlong-span data.2. Use of an error correction model that consists ECM
framework fundamental variables (including relativeproductivities, terms of trade, trade openness, and realgovernment spending ) with the potential to shape the
equilibrium RER in theLA6
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INTRODUCTION
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Why this peripheric countries?
data availability
They represent 80% of Latin America’s GDP and population
Distinct features
They have met failure and succes in their development
Subordinate position in the world economic system
The earlier studies were focused on this type of countries just a little, especially long-term studies
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INTRODUCTION
In processes with changing mean, the reversionappears faster than in processes with fixed mean.
Large deviations are fixed quicker than the smallones
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INDICES
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C
C
P
P E RER
*
E - nominal exchange rate
- consumer price index at home
- consumer price index in the comparator country C
P
*
C P
Real Exchange Rate (Symmetric definition):
k
i
it it jt RERw REER1
Multilateral Real Exchange Rate:
jt REER - Index of multilateral or effectivereal rate for country j in period t
it w -Weight corresponding to trade
partner i in period t
it RER - Bilateral real exchange rate betweencountry j and country i
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At different times, the LA6 countries adopted variousexchange rate regimes:
under some sort of pegged regime (fixed, multiple or dualregimes) for more than 70% of the time in the last century
the selection of the apppropriate rate hasfewer complications
Floating arrangements – with convertible currencies – were
rarely implemented, featuring mostly in the 1990s with theadoption of inflation targeting.
the appropriate rates selection refers tothose rates applied to import transactions
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INDICES
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RER
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INDICES
Real depreciation of domestic currency
RER Real apreciation of domestic currency
Internal price dynamics:
1920-1930s: Argentina and Mexico deflation till Great1900-1930s: Brazil and Columbia Depression
1970-1980s: Argentina, Brazil and Chile -> hyperinflation Venezuela and Mexico -> prices, exchange
rate stability
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UNIT-ROOT APPROACH
Structural breaks: Z&A methodology Min (test value) < critic level non-stationarity feature of the
series is determined by a structural break
Z&A test to REER series null hypothesis of unit-root isrejected at 10% . Except for Chile: in this case, the test issignificant for year 1945.
Testing for non-stationarity – making allowances for a one-time change in the trend function:
change in level for non-trending series additive outlier model Change in level for trending series Change in slope innovational outlier Change in level and slope model 8
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UNIT-ROOT APPROACH
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ROLE OF FUNDAMENTALS
Terms of trade, trade policy, government implications – Edward’s Dynamic Model
Economy goods:
exportable goods produced by country
non-tradable goods
importable goods consumed by country
Government - consumes importable goods and non-tradableones
- uses non-distortionary taxes and domestic creditto finance its expenditures
Long-run sustainable equilibrium export + non-tradablegoods market are in equilibrium
import tariffs
government consumption of non-tradable goods RER
terms of trade appreciation
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relative productivity tradable sector RER
appreciation
World price level exchange rate
ERROR CORRECTION MODEL (ECM)
Co-integration relationship
* - Equilibrium value
- fundamentals
k – vector of long-run multipliers
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ROLE OF FUNDAMENTALS
t xk REER *
t x
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2 conditions to fulfill:
Series are co-integrated
Fundamentals are weakly exogenous for k
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ROLE OF FUNDAMENTALS
use of single equation framework variables treated in an endogenous way
model estimated withoutimposing a long-term relationship
The last step – regression outcome – regressions are runfor each country over the whole sample in order to determinethe explanatory power of the fundamentals and estimate theerror-correction term – and its corresponding half-life value.
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CONCLUSIONS
the analyse found a very slow process of mean reversion– if any strict PPP hypothesis is rejected
The study half-life estimates are within the range of those reported in the long-span studies (after correcting
by breaks) focusing on developed countries. The averagehalf-lives for the LA6 ranges from 1½ years when theunit-root approach is used to a conservative estimate of 2½ years under the ECM model. Better results thanthe 3-5 years range of Rogoff puzzle
Related to development and economic convergence, thisstudy indicates a depreciating trend over the last century.
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