Equilibrium ER PPP: –Empirical evidence: Define: –Test the behavior of RER »If RER is non-stationary -> PPP does not hold »If RER is stationary -> PPP might hold » Conclusion (Rogoff (1986)): RER is mean reverting albeit very slowly with half statistics of mean reversion around 4 years. This is too long time period to be explained by reasonable nominal rigidities or barriers to arbitrage. Rogoff, K. (1996),”The Purchasing Power Parity Puzzle”, Journal of Economic Literature, vol. 34, June 1996, pp.:

Fact: RER is highly persistent Implications: –Problems with econometric inference –We need to explain these large swings in RER Unfortunately, many theories are lacking micro-foundations Possibly the best explanations – Balassa-Samuelson efect: –Poorer countries have cheaper price level –Improvement in productivity in tradable sector (relative to foreign country) appreciate ER. –Improvement in productivity in non-tradable sector (relative to foreign country) depreciate ER Balassa, B. (1964),”The Purchasing Power Parity Doctrine: A Reappraisal”, Journal of Political Economy, vol. 72, December, pp Samuelson, P. (1964),”Theoretical Notes on Trade Problems”, Review of Economics and Statistics, vol. 23, pp.: 1-60 Harrod, R. F. (1933), International Economics, London: James Nisbet and Cambridge University Press

Empirical evidence : B-S effect

B-S is not enough –MacDonald and Ricci (2001): Enlarged standard B-S framework by distribution sector. –MacDonald and Ricci (2002): Tested implication of new trade theory on ER. (They focus on imperfect substituability of tradables and on the importance of competitiveness) –others There is no theory (with proper micro- foundations) satisfactory explaining behavior of RER MacDonald, R. and Ricci, L. (2001),”PPP and the Balassa Samuelson Effect: The Role of the Distribution Sector”, IMF Working Paper, WP/01/38 MacDonald, R. and Ricci, L. (2002),”Purchasing Power Parity and New Trade Theory”, IMF Working Paper, WP/02/32

Example of other theories Monetary model of ER:

Let PPP condition hold only in the long-run, and assume prices are sticky in the short-run -> Dornbusch overshooting model. Able to explain excessive volatility of ER But: Why are prices sticky?

Slovak price level low

Slovak FDI inflows

Empirical development Various approaches –Most common: BEER and FEER –Persistent behavior of RER -> problems with econometric estimates –Assumption of non-stationarity cannot be satisfactory rejected due to ‘short sample’ –In all BEER estimations, RER is assumed to be I(1) – i.e. simple PPP does not hold

BEER Most common Tries to find direct behavioral link between RER and fundamentals (assumes variables to be I(1)). Absolutely no micro foundation Fundamentals: everything one suspect might affect RER

REER indices

RER (de-trended)

In-sample approach – estimates are likely biased

Unit root tests Single time serries –We performed: ADF, KPSS Kwiatkowski- Phillips-Schmidt-Shin (1992), Ng-Perron Ng- Perron (2001) –Conclusion: All series are I(1) Kwiatkowski, D., Phillips, P. C. B., Schmidt, P. and Shin, Y. (1992),”Testing the Null Hypothesis of Stationary against the Alternative of a Unit Root”, Journal of Econometrics, vol. 54, pp.: Ng, S. and Perron, P. (2001),”Lag Length Selection and the Construction of Unit Root Tests with Good Size and Power”, Econometrica, vol. 69, pp.:

Fundamentals We chose: »Proxy for Ballassa-Samuelson effect (e.g. relative price of non-tradables vs tradables (NT) or relative labour productivity in tradables vs nontradables (LP)) »(ToT) Terms of trade (i.e. export prices relative to import prices) intend to capture changes in international economic environment. »(gov) Share of government spending on GDP - intends to capture the effects of fiscal policy. »(rr) Real interest rate differential. Higher interest rate differential should attract more capital inflows. »Proxy for country risk. We used following proxies: country rating (rat), spreads on Eurobonds (spread), our currency vulnerability index adjusted for movements in RER (vul); NFA

Estimation of BEER Single country approach Able to estimate country specific behavior Short sample (about a decade), RER is highly persistentEstimates are not robust RER is likely to be undervalued for longer period in the first phase of transition Estimates are biased Plenty of ad hoc-factors affecting early stage of transition Possibility of structural breaks Questionable quality of data on the early stage of transition Measurement error Cross section approach Missing time series dimension (Impossible to account for country specific effects) Panel data approach In-sample estimates Out-of-sample estimates Including only accession countries Partially helps to solve problems connected with short sample Estimates are still biased Using data from early stage is still questionable Including broader set of countries Heterogeneity ? Helps to solve problems connected with short sample Biased L-R estimates Biased constant term Heterogeneity ? Estimates are not biased finally No constant for accession country (country-specific effect) Heterogeneity ? (is homogenous long run behavioral assumption for each country plausible?) Aims to estimate ‘specific’ behavior of countries in transition

In-sample approach - results

Improvement – panel considerations How to estimate? –Assumptions: Homogeneous L-R behavior Heterogeneous (country specific) short-run behavior Data are likely I(1) Other country specific conditions affecting L-R: –Fixed effects

Panel Unit root tests We performed: –Levin, Lin and Chu t, Levin, Lin and Chu (2002) ; Breitung t-stat, Breitung (2000) –Im, Pesaran and Shin W-stat, Im, Pesaran and Shin (2003) ; ADF - Fisher Chi-square, PP - Fisher Chi- square, Maddala and Wu (1999) and Choi(2001) –Hadri Z-stat, Hadri (2000) Conclusion: All variables are I(1) rather than I(2) or I(0)

References Levin, A., Lin, C. F., and Chu, C. (2002),”Unit Root Tests in Panel Data: Asymptotic and Finite-Sample Properties,” Journal of Econometrics, Vol. 108, pp.:1-24 Breitung, J. (2000),”The Local Power of Some Unit Root Tests for Panel Data,” in Baltagi (ed.), Advances in Econometrics, Vol. 15: Nonstationary Panels, Panel Cointegration, and Dynamic Panels, Amsterdam: JAI Press, pp.: Im, K. S., Pesaran, M. H., and Shin, Y. (2003),”Testing for Unit Roots in Heterogeneous Panels”, Journal of Econometrics, Vol. 115, pp.: Maddala, G. S., and Wu, S. (1999),”A Comparative Study of Unit Root Tests with Panel Data and A New Simple Test, Oxford Bulletin of Economics and Statistics, Vol. 61, pp.: Choi, I. (2001),”Unit Root Tests for Panel Data,” Journal of International Money and Finance, Vol. 20, pp.: Hadri, K. (2000).”Testing for Stationarity in Heterogeneous Panel Data,” Econometrics Journal, Vol. 3, pp.:

Cointegration tests We used following residual based cointegration tests: –Kao (1997) –Kao (1999) –Pedroni (1995) –Pedroni (1999) (15 tests together)

Results

ER misalignments

An out-of Sample Experiment

Alternative approach: FEER Flow approach: FEER = value of RER consistent with medium achievement of sustainable C/A balance Use of econometric models Most important: FT equations

FT equations ExportsImports

External gap at potential level

FEER

Improvement – panel evidence

Equilibrium estimates (FEER)

Conclusion Koruna will definitely be appreciating in real terms, at least for the next two decades. This is connected with fact that the country is economically just at 40% of EU average and this huge gap will continue to be diminishing slowly in the future. It is tricky to estimate the precise speed of sustainable appreciation. Data problems, short sample, and structural changes are the obvious challenges. First results point to more than 1.7% real appreciation in the years ahead. Then the pace of appreciation is likely to slow down to about % in the medium- to longer-term.

As for the current equilibrium level of Koruna, it is even more tricky to estimate it. According to the preliminary research, koruna is slightly undervalued at present – equilibrium being about Sk39.3/Eur (June). Our estimates comfortably support Sk39/€ in 4Q04 to be fully in line with macro picture or even slightly over-valuated. Furthermore, based on the preliminary (!) data, Koruna could be entering ERMII in 2006 at Sk36-37/€. Worries of CB about too strong ER at the moment might not be justified