Equilibrium and parity relationships linking exchange rates, prices and interest rates: A joint modelling approach

Nikolaos Mylonidis* & Dimitrios Sideris*

University of Ioaninna
This version: April 2005 Abstract The present paper examines the links between the main hypotheses which, as advocated by economic theory, determine the behaviour of exchange rates, in a joint modelling context. The hypotheses under consideration are the Purchasing Power Parity (PPP), the Covered Interest Parity (CIP), the Expectations Theory (ET), the Uncovered Interest Parity (UIP) and the Fisher effect (FE) hypothesis. The analysis is performed using the recently developed ARDL bounds testing approach to cointegration which can be applied regardless of whether the underlying time series are individually I(1) or I(0). The validity of the theoretical hypotheses is tested for the British Pound, Japanese Yen and Canadian Dollar (relative to the US$) over the period 1988-2004. The results provide support for the empirical verification of a number of long-run relationships and also reveal some causality dynamics between the exchange rates and their main determinants in the examined open economies. Specifically, we find evidence supporting the ET (for the UK and Japan), the CIP (for the UK and Canada), PPP (for Canada) and UIP (for Japan). The estimated coefficients of the error correction terms indicate fast convergence to long-run equilibria after a shock to the financial and goods markets. JEL classification: C32, F31.
*

University of Ioannina, Department of Economics, University Campus, 45110 Ioannina, Greece. Tel: +30 26510 95 927 / 95942. Fax: +30 26510 95093. e-mail: nmylonid@cc.uoi.gr; disideri@cc.uoi.gr

1 Introduction
In international economics, there are a number of parity and equilibrium conditions, which play a key role for the development of the literature. These relationships which are very simple as theoretical concepts have been used as cornerstones for the building of more complex theoretical analyses. Such relationships are: the Purchasing Power Parity (PPP), the Covered interest Parity (CIP), the Expectations Theory (ET), the Uncovered Interest Parity (UIP) and the Fisher effect (FE) hypothesis. The conditions are thought of as either arbitrage relationships (i.e. the UIP, the CIP) which hold continuously, or as long-run equilibrium relationships (i.e. the PPP). As a result, a substantial body of the literature has dealt with the empirical testing of the five parity conditions (among which, PPP and UIP have received most of the attention) for the post Bretton Woods floating exchange rate period (for recent surveys see inter alia Hallwood and MacDonald, 1999; Taylor and Taylor, 2004). Most of the studies have tested for the empirical verification of the conditions individually and provided mixed results for their empirical verification. Recently, a growing body of the empirical literature on international finance advocates for a joint testing of UIP and PPP, based on the argument that the two international parity relationships may not be independent of each other in the long run, since exchange rates are affected by developments in both commodity and asset markets (e.g. Ozmen and Gokcan, 2004; Caporale et al., 2001; Johansen and Juselius, 1992; Juselius, 1995; MacDonald and Marsh, 1997). In a more recent paper, Juselius and MacDonald (2004) advocate joint testing for UIP, PPP, and the term spread (TS) hypothesis to account for further possible interactions of these parity conditions. In the present paper, and following similar arguments than those of Juselius and MacDonald, (2004), we extend this nascent literature by advocating for testing of the UIP, PPP, ET, CIP and the FE hypotheses jointly. The joint modelling of these conditions allows for possible interactions in the determination of prices, interest rates and exchange rates in the good and capital markets and also takes into account the effect of the expectations formation in the capital markets. Thus, the joint modelling helps us to exploit possible extra information on the determination and the formation of the variables under consideration and leads to a better specification and better

defined results. In addition, the joint modelling may also reveal characteristics related to the exogeneity status of the variables and can thus indicate causation dynamics governing the formation of prices, interest rates and exchange rates in the economies under consideration. The five conditions are tested as equilibrium long-run relationships by applying a recently developed cointegration procedure, the Pesaran et al. (2001) bounds testing procedure. The procedure allows for different long-run relationships and short-run dynamics; this is important for the estimation of the equilibrium conditions, given that in the short run, they can be considered as describing only
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tendencies in the markets to adjust towards them . In addition, the Pesaran et al. technique can be implemented regardless of whether the variables are integrated of order (1) or (0) and can be applied to small finite samples. The paper investigates the validity of the five conditions using data from economies that are frequently chosen for the testing of international parity hypotheses and models. The hypotheses are tested for three pairs of economies: Japan -US, Canada-US and UK-US. The four economies influence strongly the good and asset markets internationally, are related to each other with important trade links and their respective currencies belong to the most traded currencies in the international financial markets. The rest of the paper is organised as follows: Section 2 briefly describes the theory underlying the five parities, whereas section 3 outlines the procedure we apply for the testing. Section 4 presents the data set and describes the applied work and results. The final section summarises and concludes.

2. Theoretical considerations
In the absence of barriers to international capital mobility, there are theoretical links among spot and forward exchange rates, interest rates and prices. More specifically,
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This is a well-known argument in the relevant studies, which test for international finance conditions applying error correction - based cointegration techniques essentially the Engle and Granger (1987) and Johansen (1988) methodologies.

one can identify five relationships, namely purchasing power parity (PPP), covered interest parity
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(CIP), Fisher effect (FE), expectations theory (ET) and uncovered interest parity (UIP). At its simplest, PPP postulates that exchange rates move according to inflation differentials, i.e., *1*00pppssst+= eq. (1) where = spot rate at present 0s = expected spot rate at time t ts p = expected inflation rate in the home country = expected inflation rate in the foreign country *p CIP ensures that profitable opportunities in the foreign exchange and interest rate markets do not last for long and that the tendency in these markets is towards equilibrium: 000*1*ssfiii=+ eq. (2) where = interest rate in the home country i = interest rate in the foreign country *i = forward rate at present 0f FE provides the missing link between PPP and CIP, namely: *1**1*pppiii+=+ eq. (3) Turning to the ET, the forward rate is considered to be an unbiased predictor of the future spot rate, meaning that if forward rate is used to predict the future spot rate, the sum of gains will equal the sum of losses: 00000ssfssst= eq. (4)
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This condition is also known as the forward market efficiency hypothesis.

Finally, UIP suggests a relationship between the interest rate differential and expected movements of the spot exchange rate. The argument is that rational investors actions in purchasing one currency and selling another will move exchange rates until excess profits from uncovered interest arbitrage are eliminated, hence bringing interest rate differentials into line with spot exchange rates and expectations of their movement: 00*1*sssiiit=+ eq. (5) Notice that (5) can also be easily derived by (2) and (4). Under the hypothesis that the forward rate is an unbiased predictor of the spot rate (eq. 4) and that CIP holds (eq. 2), we can deduce that the interest rate differential becomes an optimal predictor of the rate of depreciation. Essentially, and as a number of empirical studies have indicated, the empirical validity of two out of the three conditions (UIP, ET and CIP), implies also validity of the third (in other words, testing for e.g. CIP and ET means indirect testing for UIP). One can now combine the aforementioned five relationships to approximate the four-way
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equivalence in the foreign exchange market : 00000**sssssfppiit=== eq. (6) Clearly, eq. (6) sets out an equilibrium model relating spot and forward exchange rates, interest differentials, inflation differentials and expected movements in spot.

3. The econometric methodology

The methodological approach undertaken in this paper is the autoregressive distributed lag (ARDL) bounds testing procedure developed by Pesaran et al. (2001) which possesses two main advantages over the standard multivariate cointegration analysis (Johansen (1988), Johansen and Juselius (1990)). First, the procedure can be applied regardless the order of integration of the variables under consideration, i.e.,
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This approximation is accurate as long as low inflation economies are dealt with.

whether the variables are I(0) or I(1), and second, it can be implemented to a small finite sample, as is the case in this study. To implement the bounds testing procedure we make the assumption that the time series properties of the key variables in eq. (6) can be well approximated by a linear VAR(p) model, augmented by appropriate deterministic variables such as intercepts. Let ),(),,,(==tttttttXSPDIFFIDIFFFSz where is the expected change in the spot exchange rate, is the difference between forward and spot rates, is the difference in interest rates and is the price level differential. The conditional ARDL-ECM of interest can be written as tStFtIDIFFtPDIFF

+++++=piqjtjtjititttXSXScS1112110 eq. (7) where 1 and 2are long run multipliers, is the drift, and 0ct are white noise errors. The first step in the ARDL bounds testing approach is to estimate eq. (7) by ordinary least squares (OLS) in order to test for the existence of a long-run relationship among the variables by conducting an F-test for the joint significance of the coefficients of the lagged levels of the variables, i.e., 0: 210==H. Two asymptotic critical values bounds provide a test for cointegration when the independent variables are I(d) (where 0d1): a lower value assuming the regressors are I(0), and an upper value assuming purely I(1) regressors. If the F statistic is above the upper critical value, the null hypothesis of no long-run relationship can be rejected irrespective of the orders of integration for the time series. Conversely, if the test statistic falls below the lower critical value the null hypothesis cannot be rejected. Finally, if the statistic falls between the lower and upper critical values, the result is inconclusive. Once cointegration is ascertained the conditional long-run model for can be obtained from the reduced form solution of eq. (7) by settingtS0==XS: tttvXS++=10 eq. (8)
==

where 100c= and 121=, and are random errors. The level relationship is estimated using the ARDL approach to cointegration discussed in Pesaran and Shin (1999). This involves selecting the orders of the ARDL() model in the four variables () using standard selection criteria, and then estimating the conditional error correction model (ECM) in eq. (7) by OLS. tv4321,,,ppppttttPDIFFIDIFFFS,,,

4. The Empirical Analysis

We apply the above technique to test for the existence of a long run relationship among the four variables in eq. (6). The spot and 1-month forward exchange rate data consist of the exchange value of Pound Sterling, Japanese Yen and Canadian Dollar (relative to the US Dollar). The IDIFF variable is defined as the short term interest rate in the home country (Japan, Canada or the UK) minus the
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short term interest rate in the USA. Similarly, PDIFF is defined as the consumer price index in each of the three home countries minus the consumer price index in the USA. All data are taken from the IFS database, with the exception of the 1-month forward exchange rate which is taken from the Datastream database, and cover the monthly time frame 1988:12 to 2004:04 (185 observations). To ascertain the order of integration of the four variables we begin through applying the Phillips5

Perron (PP) and Kwiatkowski-Phillips-Schmidt-Shin (KPSS) unit root tests. The test results, presented in Table 1, yield mixed results with strong evidence in favour of the unit root hypothesis only in the cases of and . is I(0) in all instances and seems to be I(0) according to PP test, but I(1) according to KPSS test. Following the ARDL bounds testing procedure, it is possible to test for the existence of a long run relationship involving the levels of the four variables in eq. (6) irrespective of whether they are purely I(0), purely I(1), or mutually cointegrated. tIDIFFtPDIFFtStF [Table 1 here]
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The Treasury bill rate is used as the short term interest rate for Canada, the UK and the USA. The call money rate is used for Japan.
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The null hypothesis in PP test is that the variable under consideration has a unit root, whereas the null hypothesis in KPSS is that the variable is stationary.

For each country (Canada, Japan and the UK) we estimate eq. (7) and test the null hypothesis 021==. Under this null there is no cointegration among the variables. The lag lengths, p and q from eq. (7), are chosen according to the Akaike information criterion (AIC). Table 2 reports the Fstatistics associated with the aforementioned null hypothesis. Since F(SF, IDIFF, PDIFF) exceeds the upper bound of the critical value band in all instances we can reject the null of no long run relationship between the four variables irrespective of the order of their integration. Nevertheless, this test result does not allow us to identify the long run forcing variables for the expected change in the exchange rate. Hence, it is equally important to test the significance of the lagged level variables in the ECM in eq. (7) explaining tF, and . The F(FS, IDIFF, PDIFF) exceeds the upper critical value in all three cases, whereas the F(IDIFFS, F, PDIFF) and F(PDIFFS, F, IDIFF) fall either below the lower critical value or within the critical value band. tIDIFFtPDIFF [Table 2 here] Conclusively, the procedure leads to two important findings, which are common for the analysis of the three exchange rates and thus provides indications on how they are determined: i) There is evidence for a cointegrating equilibrium relationship linking spot and forward exchange rates, inflation rates and interest rates in all three pairs of economies (US-Japan, US-UK and USCanada). ii) In the three estimated cointegrating relationships, the interest rates and prices turn out to be the long-run forcing variables. This means that in the short run, prices and interest rates are not affected by the equilibrium relations; it is spot and forward exchange rates that move in order to establish the long- run equilibria. The finding makes sense: Prices are not as flexible as exchange rates in the short run (the sticky price hypothesis) whereas interest rates have been regulated by the monetary authorities in the countries under consideration, for significant time periods during the 1990s.

We can now go on and report the estimates of the parameters which describe the long- run relationships. Table 3 reports the estimates of the long-run coefficients based on ARDL models selected by AIC. For the UK, the point estimate of (tFF) in the (SF, IDIFF, PDIFF) long-run equation is 1.218 with a standard error of 0.572, hence suggesting that F does not statistically exceed unity. In other words, this result is consistent with the long-run expectations hypothesis, i.e., the forward rate is an unbiased predictor of the future spot rate. In the long-run equation (FS, IDIFF, PDIFF) the forward rate is determined by the interest rate differential (000698.0= IDIFF, standard
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error = 0.000183), thus providing some evidence for the validity of the CIP hypothesis. [Table 3 here] For Canada, the point estimates of IDIFF and PDIFF in the (SF, IDIFF, PDIFF) long-run equation is -0.0023367 (s.e. = 0.0009206), and 0.0015564 (s.e. = 0.0006351), respectively. These results are generally supportive of the existence of a long-run relationship among expected movements of the spot exchange rate, price level differential and short-term nominal interest rate differential. Further investigation of this issue reveals that the Fisher effect, which says that nominal interest rates adjust one-for-one with inflation, does not provide the missing link between PPP and CIP (the p-value of the relevant Wald test is zero), contrary to the findings of Atkins and Coe (2002) who report findings that are consistent with the Fisher effect in the USA and Canada over much of the post-war period. Finally, in the long-run equation (FS, IDIFF, PDIFF), the forward rate seems to be determined by all three independent variables with the point estimate of S having the largest impact (S=-0.044148). For Japan, the statistically significant point estimates F and IDIFF in the (SF, IDIFF, PDIFF) long-run equation provide support for the expectations and uncovered interest parity hypothesis. However, these hypotheses postulate not just that a long-run relationship exists, but also that adjust one-for-one with movements tS 6 It should be noted, however, that does not adjust one-for-one with. tFtIDIFF

in and , respectively. In other words, the long-run parameters tFtIDIFFF and IDIFF are equal to 1.0. However, the point estimates reported in Table 3 diverge significantly from unity and so we interpret these results as being partially consistent with the long run EH and UIP hypothesis. In the long-run equation (FS, IDIFF, PDIFF), the forward rate is only determined by (tIDIFF0009993.0=IDIFF, s.e. = 0.0001769), thus supporting the CIP hypothesis. [Table 4 here] The conditional ECM regressions associated with the level relationships where is the dependent variable are given in Table 4. These estimates provide further evidence on the complicated dynamics that seem to exist between and its main determinants. The results show the error correction term () is negative and statistically significant at the 1 percent level in all instances. The estimated coefficients range from -0.98502 (for Canada) to -1.0612 (for Japan), indicating immediate convergence to long-run equilibrium after a shock to the exchange rate, interest rate and goods markets. Similar conclusions are drawn for the conditional ECM regressions where is the dependent variable. The regressions fit reasonably well and generally pass the diagnostic tests against serial
st th

correlation of 1tStS1tECMtF and 4 order, heteroskedasticity and structural stability. As for the short-run correlations, it is evident from Table 4 that most lagged changes in the independent variables are either statistically insignificant, or of extremely low magnitude (<0.03). The only notable exceptions are tF for Canada (-0.98069) and )1(tFfor Japan (-0.76287) which indicate the validity of the EH in the short run. To summarise, the empirical analysis indicated that: i) There is evidence for the validity of the CIP and/or the ET hypotheses linking the forward and spot exchange rates and interest rates in the UK and the US. There is also evidence for the validity of long-run UIP and/or ET between Japan and the US. Thus, there is positive evidence for the theories which attribute the movements of the exchange rates to

financial markets forces for the cases of the Yen/ dollar and the Sterling/ dollar exchange rates; in other words, in the long run, the two exchange rates are shown to be determined by the interest rate differentials between the two economies (Japan-US and UK-US, respectively) and/or the respective forward exchange rates. ii) In the US-Canada analysis, we estimate a PPP and/or ET cointegrating relationship. The finding indicates that for the determination of the Canadian exchange rate there are strong effects coming also from the commodities market. The finding makes sense if we consider the strong trade links in the absence of high transportation costs between the US and Canada. iii) Finally, the outcomes of the short-run analysis - that in the short run, spot rates are influenced by forward rates in Canada and Japan - strengthen the argument that adjustment to equilibrium is obtained via movements of the exchange rates.

4. Conclusions
The present paper tests empirically the hypotheses of the Purchasing Power Parity (PPP), the Covered Interest Parity (CIP), the Expectations Theory (ET), the Uncovered Interest Parity (UIP) and the Fisher effect (FE), in a joint framework. The analysis is performed using the recently developed ARDL bounds testing approach to cointegration which can be applied regardless of whether the underlying time series are individually I(1) or I(0). The validity of the theoretical hypotheses is tested for the British Pound, Japanese Yen and Canadian Dollar (relative to the US$) over the period 19882004. The results provide support for the empirical verification of a number of long-run relationships and also reveal causality dynamics that exist between exchange rates and their main determinants in the examined open economies. We find evidence supporting the hypotheses which attribute the exchange rate movements to financial markets forces (the hypotheses of UIP, CIP and ET) for the Yen/ dollar and the Sterling/ dollar exchange rates. For the Canadian dollar/US dollar rate there is evidence for PPP and ET, indicating the presence of effects coming also from the goods market. The analysis also reveals that adjustment to equilibrium comes via movements of the spot and forward exchange rates and not via movements of prices and interest rates. The finding is in line with the sticky price hypothesis and

the fact that interest rates have been regulated in the four analysed economies for long sub-periods during the period under consideration.

References
Atkins, F. J. and P. J. Coe, 2002, An ARDL bounds test of the long-run Fisher Effects in the United States and Canada, Journal of Macroeconomics, 24, 255-66. Caporale, G. M., Kalyvitis S. and N. Pittis, 2001, Testing for PPP and UIP in an FIML framework: Some evidence for Germany and Japan, Journal of Policy Modeling, 23, 637-650. Engle, R. F. and C. W. J. Granger, 1987, Co-integration and error correction: representation and testing, Econometrica, 55, 251-76. Hallwood, P. and R., MacDonald, 1999, International Money and Finance, third edition, Oxford: Basil Blackwell. Johansen, S., 1988, Statistical Analysis of Cointegration Vectors, Journal of Economic Dynamics and Control, 12, 231-54. Johansen, S. and K. Juselius, 1992, Testing structural hypotheses in a multivariate cointegration analysis of the PPP and UIP for UK Journal of Econometrics, 53, 211-244. Juselius, K., 1995, Do Purchasing Power Parity and Uncovered Interest Parity Hold in the Long Run? An Example of Likelihood Inference in a Multivariate Time-Series Model, Journal of Econometrics, 69, 211-40. Juselius, K. and R. MacDonald, 2004, International Parity Relationships between the US and Japan, Japan and the World Economy, 16, 17-34. MacDonald, R. and I. W., Marsh, 1997, On fundamentals and Rxchange Rates: A Cassellian perspective, Review of Economics and Statistics, 78, 655-664. Ozmen, E. and A. Gokcan, 2004, Deviations from PPP and UIP in a financially open economy: the Turkish evidence, Applied Financial Economics, 14, 779-784. Pesaran, M. H., Shin, Y. and R. J. Smith, 2001, Bounds Testing approaches to the analysis of level relationships, Journal of Applied Econometrics, 16, 289-326. Taylor, A. M. and M. P. Taylor, 2004, The Purchasing Power Parity Debate, Journal of Economic Perspectives, 18, 135-158.

Table 1
Unit root tests Countries S F IDIFF PDIFF PP KPSS PP KPSS PP KPSS PP KPSS UK -12.478* 0.094 -12.074* 0.619 -1.459 0.908* -3.393* 0.682** Canada -13.413* 0.319 -10.489* 1.320* -1.588 0.970* -0.626 1.486* Japan -12.496* 0.073 -12.843* 0.393 -1.314 0.507** 5.678* 1.578* Notes. The critical values for PP at 10%, 5% and 1% significance level are 1.615, -1.942 and -2.577; for those for KPSS are 0.347, 0.463 and 0.739, respectively. *** denotes the rejection of the null at 10% significance level; ** denotes the rejection of the null at 5% significance level; * denotes the rejection of the null at 1% significance level.

Table 2 Bounds tests, F-statistics Countries Dep. Var. Lags F-statistic Outcome a UK S 1 20.561 Cointegration a F 1 21.710 Cointegration c IDIFF 1 2.593 No cointegration b PDIFF 1 3.219 Inconclusive a Canada S 1 23.039 Cointegration a F 1 18.254 Cointegration c IDIFF 1 1.028 No cointegration c PDIFF 1 2.110 No cointegration a Japan S 3 14.727 Cointegration a F 3 10.733 Cointegration c IDIFF 3 2.639 No cointegration c PDIFF 3 1.215 No cointegration Notes: The lag order is selected on the basis of the Akaikes Information Criterion (AIC). The F-statistic is used to test for the joint significance of the coefficients of the lagged levels in the ARDL-ECM. Asymptotic critical values are obtained from Table CI(iii) Case III: unrestricted intercept and no trend for k=3 (Pesaran et al., 2001, p. 300). a b c indicates that the statistic lies above the 0.10 upper bound; that it falls within the 0.10 bounds; that it lies below the 0.10 lower bound. Table 3 Estimated Long-Run Coefficients Using the ARDL Approach Countries Dep. ARDL S F IDIFF PDIFF UK S (1,1,1,0) - 1.218** 0.0013 0.0014 F (1,0,0,0) 0.013 - -0.0007* 0.0004 Canada S (1,1,1,2) - 0.231 -0.002** 0.002** F (1,0,0,2) -0.044* - 0.0004** 0.0003** Japan S (4,2,3,0) - 2.281* -0.0046* 0.0003 F (2,0,0,0) 0.024*** - 0.001* <0.0001 Notes: The lag specification of the ARDL is selected based on AIC. * denotes statistically significant coefficient at 1% level; ** statistically significant at 5% level; *** statistically significant at 10% level.

Table 4 Error Correction Representations for the Selected ARDL Models Dependent Variable Country Ind. Var. S F UK C 0.0004 (0.897) 0.0006 (0.266) S - 0.013 (0.331) F 0.232 (0.577) IDIFF 0.029 (0.000) -0.0007 (0.000) PDIFF 0.001 (0.443) 0.0004 (0.228) ECT(-1) -1.022 (0.000) -0.992 (0.000) 2 Adj. R 0.51262 0.48013 SC1 0.355 0.058 SC4 0.592 0.183 White 0.065 0.226 Canada C -0.001 (0.543) -0.001 (0.001) S - -0.039 (0.005) F -0.980 (0.012) IDIFF 0.008 (0.001) 0.0004 (0.019) PDIFF 0.003 (0.394) 0.0001 (0.902) PDIFF(-1) -0.008 (0.043) -0.001 (0.043) ECT(-1) -0.985 (0.000) -0.885 (0.000) 2 Adj. R 0.57676 0.47503 SC1 0.738 0.268 SC4 0.243 0.825 White 0.986 0.523 Japan C -0.008 (0.053) 0.0005 (0.556) S(-1) 0.085 (0.482) 0.030 (0.057) S(-2) 0.139 (0.171) S(-3) 0.192 (0.010) F 0.676 (0.053) F(-1) -0.762 (0.034) 0.185 (0.014) IDIFF -0.025 (0.024) 0.001 (0.000) IDIFF(-1) 0.014 (0.210) IDIFF(-2) 0.019 (0.078) PDIFF 0.0003 (0.359) <-0.0001(0.374) ECT(-1) -1.061 (0.000) -1.294 (0.000) 2 Adj. R 0.50833 0.54208 SC1 0.006 0.156 SC4 0.045 0.339 White 0.266 0.041 Notes: p-values are in parentheses. ECT is the error correction Term. SC1 and SC4 are the Lagrange multiplier
tests for serial correlation at lags 1 and 4 distributed as with 1 and 4 degrees of freedom, respectively. White stands for Whites test for heteroskedasticity of the residuals.
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