International Macroeconomics and

Finance: Theory and Empirical Methods

Nelson C. Mark

December 12, 2000 forthcoming, Blackwell Publishers

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To Shirley, Laurie, and Lesli

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Preface

This book grew out of my lecture notes for a graduate course in international macroeconomics and Þnance that I teach at the Ohio State University. The book is targeted towards second year graduate students in a Ph.D. program. The material is accessible to those who have completed core courses in statistics, econometrics, and macroeconomic theory typically taken in the Þrst year of graduate study.

These days, there is a high level of interaction between empirical and theoretical research. This book reßects this healthy development by integrating both theoretical and empirical issues. The theory is introduced by developing the canonical model in a topic area and then its predictions are evaluated quantitatively. Both the calibration method and standard econometric methods are covered. In many of the empirical applications, I have updated the data sets from the original studies and have re-done the calculations using the Gauss programming language. The data and Gauss programs will be available for downloading from my website: www.econ.ohio-state.edu/Mark.

There are several di erent ‘camps’ in international macroeconomics and Þnance. One of the major divisions is between the use of ad hoc and optimizing models. The academic research frontier stresses the theoretical rigor and internal consistency of fully articulated general equilibrium models with optimizing agents. However, the ad hoc models that predate optimizing models are still used in policy analysis and evidently still have something useful to say. The book strikes a middle ground by providing coverage of both types of models.

Some of the other divisions in the Þeld are ßexible price versus sticky price models, rationality versus irrationality, and calibration versus statistical inference. The book gives consideration to each of these ‘mini debates.’ Each approach has its good points and its bad points. Although many people feel Þrmly about the particular way that research in the Þeld should be done, I believe that beginning students should see a balanced treatment of the di erent views.

Here’s a brief outline of what is to come. Chapter 1 derives some basic relations and gives some institutional background on international Þnancial markets, national income and balance of payments accounts, and central bank operations.

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Chapter 2 collects many of the time-series techniques that we draw upon. It is not necessary work through this chapter carefully in the Þrst reading. I would suggest that you skim the chapter and make note of the contents, then refer back to the relevant sections when the need arises. This chapter keeps the book reasonably self-contained and provides an e cient reference with uniform notation.

Many di erent time-series techniques have been implemented in the literature and treatments of the various methods are scattered across di erent textbooks and journal articles. It would be really unkind to send you to multiple outside sources and require you to invest in new notation to acquire the background on these techniques. Such a strategy seems to me expensive in time and money. While this material is not central to international macroeconomics and Þnance, I was convinced not to place this stu in an appendix by feedback from my own students. They liked having this material early on for three reasons. First, they said that people often don’t read appendices; second, they said that they liked seeing an econometric roadmap of what was to come; and third, they said that in terms of reference, it is easier to ßip pages towards the front of a book than it is to ßip to the end.

Moving on, Chapters 3 through 5 cover ‘ßexible price’ models. We begin with the ad hoc monetary model and progress to dynamic equilibrium models with optimizing agents. These models o er limited scope for policy interventions because they are set in a perfect world with no market imperfections and no nominal rigidities. However, they serve as a useful benchmark against which to measure reÞnements and progress.

The next two chapters are devoted to understanding two anomalies in international macroeconomics and Þnance. Chapters 6 covers deviations from uncovered interest parity (a.k.a. the forward-premium bias), and Chapter 7 covers deviations from purchasing-power parity. Both topics have been the focus of a tremendous amount of empirical work.

Chapters 8 and 9 cover ‘sticky-price’ models. Again, we begin with ad hoc versions, this time the Mundell—Fleming model, then progress to dynamic equilibrium models with optimizing agents. The models in these chapters do suggest positive roles for policy interventions because they are set in imperfectly competitive environments with nominal rigidities.

Chapter 10 covers the analysis of exchange rates under target zones.

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We take the view that these are a class of Þxed exchange rate models where the central bank is committed to keeping the exchange rate within a speciÞed zone, although the framework is actually more general and works even when explicit targets are not announced. Chapter 11 continues in this direction by with a treatment of the causes and timing of collapsing Þxed exchange rate arrangements.

The Þeld of international macroeconomics and Þnance is vast. Keeping the book su ciently short to use in a one-quarter or one-semester course meant omitting coverage of some important topics. The book is not a literature survey and is pretty short on the history of thought in the area. Many excellent and inßuential papers are not included in the citation list. This simply could not be avoided. As my late colleague G.S. Maddala once said to me, “You can’t learn anything from a fat book.” Since I want you to learn from this book, I’ve aimed to keep it short, concrete, and to the point.

To avoid that ‘black-box’ perception that beginning students sometimes have, almost all of the results that I present are derived step-by- step from Þrst principles. This is annoying for a knowledgeable reader (i.e., the instructor), but hopefully it is a feature that new students will appreciate. My overall objective is to e ciently bring you up to the research frontier in international macroeconomics and Þnance. I hope that I have achieved this goal in some measure and that you Þnd the book to be of some value.

Finally, I would like to express my appreciation to Chi-Young Choi, Roisin O’Sullivan and Raphael Solomon who gave me useful comments, and to Horag Choi and Young-Kyu Moh who corrected innumerable

(1) mistakes in the manuscript. My very special thanks goes to Donggyu Sul who read several drafts and who helped me to set up much of the data used in the book.

5.1Calibrating the One-Sector Growth Model . . . . . . . . 138

5.2Calibrating a Two-Country Model . . . . . . . . . . . . . 149

6.1Deviations From UIP . . . . . . . . . . . . . . . . . . . . 162

6.2Rational Risk Premia . . . . . . . . . . . . . . . . . . . . 172

6.3Testing Euler Equations . . . . . . . . . . . . . . . . . . 177

6.4 Apparent Violations of Rationality . . . . . . . . . . . . 183

6.5The ‘Peso Problem’ . . . . . . . . . . . . . . . . . . . . . 186

6.6Noise-Traders . . . . . . . . . . . . . . . . . . . . . . . . 193

7.1Some Preliminary Issues . . . . . . . . . . . . . . . . . . 208

7.2Deviations from the Law-Of-One Price . . . . . . . . . . 209

7.3Long-Run Determinants of the Real Exchange Rate . . . 213

7.4Long-Run Analyses of Real Exchange Rates . . . . . . . 217

8.2Dornbusch’s Dynamic Mundell—Fleming Model . . . . . . 237

8.3A Stochastic Mundell—Fleming Model . . . . . . . . . . . 241

8.4VAR analysis of Mundell—Fleming . . . . . . . . . . . . . 249

9.1The Redux Model . . . . . . . . . . . . . . . . . . . . . . 264

9.2Pricing to Market . . . . . . . . . . . . . . . . . . . . . . 286

10.4Discrete Intervention . . . . . . . . . . . . . . . . . . . . 319

10.5Eventual Collapse . . . . . . . . . . . . . . . . . . . . . . 320

10.6Imperfect Target-Zone Credibility . . . . . . . . . . . . . 322

11.1A First-Generation Model . . . . . . . . . . . . . . . . . 328

11.2A Second Generation Model . . . . . . . . . . . . . . . . 335