Asset Market and Balance of Payments Characteristics - An Eclectic Exchange Rate Model for the Dollar, Mark, and Yen


WP/95/55-EA
Asset Market and Balance of Payments Characteristics: An Eclectic
Exchange Rate Model for the Dollar, Mark, and Yen by Ronald MacDonald

Recently there has been a resurgence of interest in modeling long-run
real and nominal exchange rates. In large part, such interest has arisen
because the stylized fact that freely floating exchange rates are rarely, if
ever, at their equilibrium levels has generated a desire to understand just
how far away from equilibrium a current exchange rate might be. For
bilateral exchange rates, a growing body of evidence suggests that some form
of stable 'long-run' relationship exists between exchange rates and
fundamentals, particularly relative prices. This latter relationship,
however, does not conform exactly to what would conventionally be regarded
as purchasing power parity (PPP), in that often, particularly for U.S.
dollar bilateral rates, standard symmetry and degree one homogeneity
restrictions (implied by absolute PPP) are strongly rejected and the implied
mean reversion of the real exchange rate is very slow. There would
therefore appear to be more to exchange rates than simply relative prices.

In this paper, the recent work on long-run exchange rate relationships
is taken as the point of departure and combined with a theoretical model of
exchange rate determination--a hybrid asset market or balance of
payments model--to examine the determinants of nominal exchange rates.
From an empirical perspective, the model has two appealing features. It
incorporates a key element of the asset approach to exchange rate modeling,
namely, that an asset price is related to the present value of expected
future fundamentals, along with elements of a more traditional balance of
payments or portfolio balance approach, in which real factors can have an
important bearing on the nominal exchange rate, even in equilibrium. A key
aspect of this latter feature is the issue of sustainability.

The hybrid asset market or balance of payments model considered in this
paper, labeled an eclectic exchange rate model (EERM), is implemented for
the effective exchange rates of the deutsche mark, Japanese yen, and U.S.
dollar over the period 1973 Q3 to 1993 Q4. It is demonstrated that the EERM
produces sensible estimates of the long-run values of these exchange rates,
whereas simple PPP does not. Interestingly, the actual value of the
Japanese yen stays very close to its equilibrium value throughout the
period, whereas both the deutsche mark and dollar are often quite far away;
this is especially so for the U.S. dollar in the period coinciding with its
dramatic appreciation in the early 1980s. The short-run dynamic equations
implied by the long-run exchange rate systems are deemed reasonably
successful on the basis of standard criteria. The paper concludes by
arguing that the approach adopted warrants further attention, particularly
in terms of the data requirements necessary to implement it for bilateral
exchange rates.