1. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar Should the Croatian National Bank Devaluate the Exchange Rate? Evidence from Purchasing Power Parity

2. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar Content PPP hypothesis Review of empirical research Data Methodology Results Policy implications

3. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar PPP hypothesis Exchange rate that equates domestic and foreign price levels so that the purchasing power of a unit of one currency would be the same in both economies (Sarno and Taylor, 2001) One of the most extensively tested theoretical propositions Intuitive and simple  We wanted to test whether ppp holds in Croatia since the debates about the overvaluation of the nominal hrk/eur exchange rate are quitte common

4. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar Review of empirical research Consensus concerning the validity of PPP appears to have shifted several times in the post-war period The prevailing view is that long-run PPP does have some validity, although a number of puzzles have yet to be resolved For transition countries results seem less conclusive  reasons stem from characteristics of transition economies Most of transition economies suffered external and internal shocks, high inflation and/or major exchange rate shifts Nonlinear tests more succesful in detecting PPP for developing countries when compared to linear tests Croatia: till now authors tested only for linear ppp (unit root, cointegration and panel data tests)  contradictory results

5. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar Data To test the PPP theory we needed:  Monthly average nominal HRK/EUR exchange rate  Monthly Croatian consumer price index  Monthly harmonized index of consumer prices for EMU All data range from January 2000 to December 2009

6. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar HRK/EUR

7. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar Croatian CPI

8. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar Eurozone HCPI

9. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar HRK/EUR in first differences

10. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar Croatian CPI in first differences

11. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar Eurozone HCPI in first differences

12. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar Methodology Two cointegration methods: -Johansen cointegration: symmetry in both the short and long run -Threshold cointegration: asymmetry in short and symmetry in the long run  Enders and Siklos (2001) Vector error correction models

13. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar Results – Johansen cointegration Two cointegrating vectors: 1.Absolute PPP condition 2.Long run relationship between domestic and eurozone price level RankEigenvalueTrace testMax testTrace test (T-nm) Max test (T-nm) 0-62.42 [0.000]*42.15 [0.000]*59.25 [0.000]* 40.01 [0.000]* 10.300420.27 [0.048]**18.61 [0.016]**19.24 [0.068] 17.67 [0.024]** 20.14591.66 [0.836]1.66 [0.835]1.57 [0.850] 1.57 [0.849] 30.0139----

14. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar Results – Johansen cointegration Restrictions: First cointegrating vector: -long run coefficients for the exchange rate should be equal to 1 -long run coefficients for EMU prices should be equal to 1 -long run coefficient for domestic prices should be equal to -1 -in the short run EMU prices are weakly exogenous Second cointegrating vector: –long run coefficients for the exchange rate should be equal to 0 –long run coefficient for domestic prices should be equal to 1 Variables Long run (1. vector) Short-run (1. vector) Long run (2. vector) Short-run (2. vector) β coefficientsα coefficientsβ coefficients α coefficients Exchange rate1.0-0.236- -0.286 Domestic prices 0.02351.0 0.0168 EMU prices1.00-0.871 -0.0076 Constant -0.7717--0.340-

15. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar Results – VECMs’ Dependant variableΔ Exchange rateΔ Domestic pricesΔ EMU prices Constant 9.98252e-5 (0.066) 0.00013 (0.066) -8.6e-6 (-0.015) Δ Exchange rate(-1) 0.192 (1.52) 0.0175 (0.32) -0.029 (-1.38) Δ Domestic prices(-1) -0.055 (-0.251) 0.038 (0.34) 0.069 (1.43) Δ EMU prices(-1) -0.884* (-2.205) 0.187 (0.74) 0.062 (0.44) ECT_PPP(-1) -0.236* (-3.84) 0.023 (0.68) 0.0004 (0.031) ECT_INFLATION DIFFERENTIAL(-1) -0.2853* (-3.70) 0.0189 (0.44) -0.007 (-0.36)

16. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar Results 1.Absolute power parity holds in the long run 2.Exchange rate adjusts to deviations from the parity in the short run 3.Price level in Croatia and the eurozone are weakly exogenous 4.Higher inflation in Eurozone leads to appreciation of nominal HRK/EUR exchange rate in the short run 5.No proof of exchange rate pass-through to domestic consumer prices 6.Adjustments of deviations from the PPP is not asymmetric

17. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar Policy implications 1.Devaluation is not an appropriate policy response 2.Nominal rigidity in the economy should be decreased 3.More nominal exchange rate variability  when no structural characteristics are taken into account * Exchange rate is flexible enough to correct discrepancies in prices; performs its basic economic function

18. Should the CNB Devaluate the Exchange Rate? 23/06/2010 Dubrovnik Marina Tkalec - Maruška Vizek 16 th Young Economists’ Seminar Results - TAR and M-TAR TARM-TARTARM-TAR Threshold = 0 Threshold = 0.0131Threshold = 0.00018 Parameters and tests values Parameters and tests values Parameters and tests values Parameters and tests values ρ1=ρ1= -0.071 ρ 1 = -0.121 ρ 1 = -0.086 ρ 1 = -0.128 ρ 2 =-0.067ρ 2 =-0.018ρ 2 =-0.056ρ 2 =-0.012 Tmax-1.24Tmax-0.36Tmax-1.14Tmax-0.247 Φ(ρ 1 = ρ 2 = 0) 2.10 Φ(ρ 1 = ρ 2 = 0) 3.45 Φ(ρ 1 = ρ 2 = 0) 2.35 Φ(ρ 1 = ρ 2 = 0) 3.78 W(ρ 1 = ρ 2 ) 0.003 (0.96) W(ρ 1 = ρ 2 ) 2.31 (0.12) W(ρ 1 = ρ 2 ) 0.19 (0.66) W(ρ 1 = ρ 2 ) 2.95 (0.09) AR test0.96 (0.46) AR test0.83 (0.56) AR test0.85 (0.55) AR test0.84 (0.55)