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Dissertatlon subfiitted to the University of Dethi in partial fullillment of the requirements for the award sf the degree of
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MASTEN OT PHILOSOTTTV
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Department of Economics Delhi School of Economics University of Delhi Delhi - I'10 (m7
India
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suUmiited in part or fuil for
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This is to ce,rtiff that this otudy *Exchangs Rate Modets for India : An appaisal of
is based on my original'resemb {ront. My indeb,ted e to
other works/publicatiirns has been duly ackriowldgd
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Ackuowledgement
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am grateful to my supervisor Dr.Pami Dua for the enormous patie,lrce aria irrtsest
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SAMRAT BHATTACHARYA
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TABLE OF CONTENTS
CHAPTER
I:
Introduction
Survey of Literature
.....1
CHAPTERII:
Section
.....
. .
.........6
A.
Determination .. .:. .. ....6 Section B Empirical Survey of Asset Markets Models. ...,:.......:.......16 Section B (I). EstimationResults ..:..... .........16 Section B(II) Out-of-Sample Forecasting Performance.. .....29
CHAPTER
Methodology Section A. Unit Root Tests . ... .. . Section B. Box-Jenkins Methodology.......::.. Section C. Cointegration Methodology Section D. Vector Autoregression Methodglogy
Econometric
.
III:
......42
..........42
......48
......50
.....52
.... .. ..61
..
CHAPTER
IV: :
Measures
CHAPTER V
Definitions.
....73
CHAPTERYI:
EmpiricalResults ........:.::..::... ......74 Section A. UnitRootTests. ....:... :..:....:.....:.... ..........75 Section B. Cointegrationlong-Run equilibrium & Vector error Correction Model ......... ......:...86 Section C. BayesianvAR... ......,......... ........:.....,95 Section. D. ARIMA .. .....9:9 :...
. .
CHAPTERVII:
Bibliography Appendix
Conclusion
Result.
......124
Chapter
INTRODACTION
to
of
.
exchange and exchange ratios suggests that there are broadly three kinds of prices
relative prices, which reflect the exchange of goods for other goods and which exist in
both barter and monetary economies ; money prices, which reflect the exchange of money for other goods, and exists only
the
general level of prices, which reflects the average price of all commodities and exists
only in an economy with money. However, there is a fourth kind of price which is
of
our interest. This is the price of one money (or medium of exchange) in terms of
another money (or medium of exchange). Hence, rather than exchanging money for goods or services, money can be exchanged for another money. This price is called the exchange rate. The exchange rate may be defined as the domestic price of foreign currency, or as its reciprocal, the foreign price of domestic curency. In this paper, we employ the former definition.
till
of
aim of bringing India in line with the world economy. There was a seachange in the Indian foreign exchange market after the economic liberalisation of 1991. In the pre-
liberalisation era, the basketJinked exchange rate policy regime, with the RBI
performing a market clearing role, provided very limited freedom to the market. The
post-1991 period, however, saw a movement towards a market-determined exchange
rate regime following the recommendations of the High Level Committee on Balance
in India (Chairman :
more operational freedom to dealing banks and widening and deepening of the
markets. The principle underlying the conduct of the exchange rate policy under the
market based regime is to allow the market forces determine the exchange rate with the monetary authority ensuring that the exchange rate reflects the fundamentals
the economy.
of
One needs to better understand the behaviour of the spot exchange rate in the new open economic environment in India. There is now more need to produce forecasts
of
the exchange rate as it affects the economic agents in a far greater way than it used to
do a decade ago. Business houses, in this new environment, need to have 'good'
forecast of the exchange rate so that they can take adequate measures to minimise the
exchange rate related risks. Government also needs a 'good' forecast
of exchange rate.
This is more so for an underdeveloped country like India where imports are a major
component of trade. Any major fluctuation in the exchange rate could affect import
(as
well
for the commodities like crude oil. So it will be advantageous for the government to
have 'reliable' and 'good' forecast of the exchange rate so that they can hedge to avoid any adverse implications. Moreover, given the poor performance of the exchange rate
models,
it
becomes challenging
exchange rate
"
Is
Random Walk the best forecasting model ?". This question has haunted forecasters
since the seminal work of Meese and Rogoff(1983). Lot of research work has got into
this but without much sucsess. The present study is another attempt in this direction.
Here an attempt has been made to model the exchange rate dynamics iir a way so as to
generate accurate, rational and efficient forecast. The present study is the culmination
of the two earlier research work by the same author. Bhattacharya (199S) attempted to model exchange rate by Box-Jenkins methodology, while another study (1999) tested
these papers,
random walk turned out to be a better performer over other competing models, barring
the univariate ARIMA models, in terms of out-of-sample forecast performance. The present study attempts
OBJECTIVES :
We lay out some specific objectives of the proposed study. Most important and the root of all the heated discussion lies the argument that the
exchange rate follows a random walk. So
it
whether exchange rate follows a random walk or not. We work with the US-India
spot exchange rate. We propose to use the traditional unit root tests like
(Augmented Dickey-Fuller)
the
drawback of these traditional and most popular test we intend to employ other
tests for unit root, like KPSS (Kwiatkowski, Phillips, Schmidtand Shin (Tgg2)) test, Bayesian unit root test. For a detailed discussion of these tests the readers are
requested to refer to chapter IfD.
of exchange rate
determination
of
the
estimation models. To avoid any arbitrary restriction on the data generating process, one moves into the realm
of
atheoretical modelling
like
Vector
Autoregressive Regression (VAR). The concept of Cointegration helps us to test the monetary models in a cointegrating framework and leads to the estimation
of
but also the forecaster's personal belief about how the economy behaves and
where it is heading at any moment. So a task of forecaster, in practice, is to blend
data and personal belief according to a subjective procedure. Bayesian Vector Autoregressions (BVAR) model attempts to blend forecaster's subjective belief
and data in a scientific way (refer chapter
III).
of their forecasting
the time series properties of the actual and predicted series to evaluate the
forecasting performance of the competing models.(All these tests are discussed in Chapter IV).
ffi
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Chapter
II
reviews the
IV
describes the
various forecast Evaluation measures employed in tho pr6$ent study; Chapter V grves
the data source and definition of the variables used in this study; Chapter VI provides
a detailed aualysis of the empirical recults obtained and
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Chapter
II
SURWY OF LITERATURE
exposition to the various theories of the exchange rate determination. We discuss the
II
rate
the
estimation results of the asset market models of exchange rate determination with a
II.B briefly
supply and demand curves in the foreign exchange market. Since the exchange rate
began
to float in the 70s, their fluctuations have resembled those of asset market
prices. Rather than following the movement of relative price levels, exchange rate
movements seem to be dominated by monetary conditions. The theoretical literature
of
exchange rate
determination. The theoretical assumption that all asset-market models share is the
absence
flow of capital between countries. However, beyond this common point, the
market models diverge in a number of different and complex routes.
The uncovered interest parity must hold. However, then bond supplies become
irrelevant, and the exchange rate is determined in the money market. Such models
belong to the 'monetary approach' of exchange rate determination, which focuses on
the demand and supply of money. Within the monetary approach, however, there are
] it is
in the nominal
interest rate reflect changes in the expected inflation rate. The relative increase in the domestic interest rate compared to the foreign interest rate implies that the domestic
currency is expected to loose value through inflation and depreciation. Demand for
the domestic currency falls relative to the foreign currency, which causes
it to
depreciate instantly. So, we get a positive relationship between exchange rate and
nominal interest differential. The second strand of models I Dornbusch (1976) ] assumes that prices
are sticky, at least in the short-run. Consequently, changes in the nominal interest rate
reflect changes in the tightness of monetary policy. When the domestic interest rate
rises relative to the foreign rate
it is because
domestic money supply relative to the domestic money demand without a matching
fall in prices. The higher interest rate at home attracts a capital inflow, which
causes
gd a negative
relationship
the
exchange rate and the nominal interest differential. This model is also
appreciate
rate determination, in which asset holders wish to allocate their portfolios in shares that are well-defined functions of expected rates of return. According to the portfolio-
of the
of the rate of
accumulation ofthese assets exert profound first-order effects on the exchange rate.
functions for the domestic and foreign economies. Monetary equilibrium in the domestic and foreign country, respectively, are given by
7n=
p+Q
y-)"i
(1)
(2)
and
m*
=p*+0y*-)"i* m:
of
log of the money supply
where
p
log
y:
/: )" :
affect demands for domestic and foreign monies, and third are those which affect the
relative price structures.
The flexible price model has been criticised for its assumptions of
continuous PPP. Under continuous PPP, the real exchange rate,i.e., the exchange rate
adjusted
for
differences
characteristics of the floating exchange rate regime has been the wide gyrations in the
real exchange rates between many of the major currencies. This led to the second
generation of monetary models pioneered by Dornbusch (1976)'
In this model PPP does hold in the long-run, so that a given increase tn
the money supply raises the exchange rate proportionately as in the monetarist model,
but only in the long-run. However, in the short run, because of sticky prices,
monetary expansion leads to a fall in the interest rate. This leads to capital outflow,
causing the exchange rate to depreciate instantaneously to give rise to the anticipation
of appreciation at just suflicient a rate to offset the reduced domestic interest rate,
so
that the uncovered interest rate parity hold. This model thus explains the paradox that countries with relative high interest rates tend to have currencies whose exchange rate
is expected to depreciate. However, the above analysis is done under the assumption of full employment so that the real output is fixed. If output, on the contrary, responds
to aggregate demand, the exchange rate and interest rate changes will be dampened.
11
From
(l)
*)+0 0 - y x1 * l(i -m *) = (p - p
-i*)
(3)
s=p-p*
(4)
Using the PPP condition we get the formulation of the monetary model which has been extensively used in the empirical literature
s = (m
:
(s)
This says that an increase in the domestic money stock, relative to the foreign money
stock,
will lead to a rise in s, that is, in a fall in the value of the domestic currency in
terms of foreign currency (depreciation). An increase in domestic output appreciates the domestic currency, i.e. a fall in s (/>0). This is because an increase in domestic
real income creates an excess demand for the domestic money stock. As agents try to increase their (real) money balances, they reduce expenditure and prices
fall until of
the domestic currency in terms of foreign culrency. Similarly, a rise in the domestic
interest rate reduces the demand for money and prices increase to maintain the money
market equilibrium and via PPP leads to a depreciation of the domestic culrency
(2>0).
There is another alternative but equivalent way of formulating the flexible
price model by imposing the uncovered interest parity condition on equation (5). Uncovered interest rate parity implies that
i-ix = E(As)
where,
(6)
Z(As)
s:
- (m - m*)- 0 0 - y*)+zE(As)
(7)
If the expectations are assumed to be rational, then by iterating forward, we can obtain
the
(t+2)'Zr|}7'l(*-*.)"
,*,td!",*i*{*
y,**"
(8)
The superscript " e " stands for the expectations which are conditioned on information set at time t. From equation (8)
it
expectations, involves solving for the expected future path of the " driving variables "
- that is, relative money supply and income.
The assumption that the prices relevant for money market equilibrium
are the same as those relevant for the PPP can be relaxed
p=o px+(1-o) pr
p,
goods, and
pr=S*p*r
This gives us the monetary model equation of the form
,*
p* *))
[assuming
o=o*)
10
and the Although the exchange rate will still depreciate, it may no longer overshoot,
and
m= p+g
y-
)"i y*-Ai*
(l)
Q)
(3)
.
m* =p*+0
i-i4= E(As)
However, it replaces the instantaneous PPP condition with a'long run version
s=p-P
In the short ruq when the exchange rate deviates from its equilibrium path, it
expected to close the gap with a speed of adjustment is
E(As) = -0(s-s)
The equation of exchange rate determination is given by
s
(m
*m *)-
0 - Y*)*(1/AX i -i *)
price monetary model, Since the prices are perfectly flexible in the long run,
proportionality between money supply and prices holds in the long run which by PPP
(which also holds in the long run) imply a coefftcient of one of the relative money
arises supply term. However, the difference with the flexible price monetary model
price when one considers the sign of the interest differential. In case of the flexible positive, monetary model the sign of the coeflicient of the interest differential is
whereas in case of the Dornbusch model
it is negative
(f <0)'
t2
drawback
of the
Dornbusch (1976)
it
E(As) = -d(s-F)+(n-r*)
where, fr ,fr
This says that the expected rate of depreciation is a function of the gap between the current spot rate and an equilibrium rate, and of the expected long run inflation
differential between the domestic and foreign countries. The theory yields an equation
of exchange rate determination in which the spot rate is expressed as a function of the
relative money supply, relative income level, the nominal interest differential (with
sign hypothesized negative), and the expected long run inflation differential (with sign hypothesized positive).
(m
*) *)+ (n - m *) + 0 Q - y +a (r - r B
:
r*)
'. d>0,0<0,F=0
a<0,5<0,F=0
0
: a<0,Q<0,p>
13
of the
exchange rate
in
maintaining continuous
It
short run, by supply and demand in the markets for financial assets. The exchange rate, however, is a principal determinant of the current account of the balance of
payments. The PBM is inherently dynamic model of exchange rate adjustment, which combines the asset market, the current account, the price level, and the rate of asset
is
that
it
assumes imperfect
substitution between domestic and non-money assets. In addition, the PBM is stock-
flow consistent, in that it allows for current account imbalances to have a feedback
effect on wealth and hence, on long run equilibrium. We consider a small open economy model due to Branson et.al (1977), where domestic residents hold domestic money stock, M, which are dominated in
home currency; domestically issued non money assets B ( i.e., domestic bonds ) ; and
foreign-issued non money asset F, which are denominated in foreign exchange. The current account in the BoP gives the rate of accumulation of F overtime. The total
supplies of the three assets M, B, and F, to domestic holders are given at each point
of
,*,
t4
expected rate
domestic interest rate r, which is to be determined in the domestic financial market. The asset market equilibrium conditions are given by
<0,m, <0)
sF * -f (, ,r* + s)W
(.f , < O, .f
> O)
G) W = M
+B+sF
that I r,l ,
tl *a frlrln ,l
I
Thg case where the assets are perfect substitutes is given bV "f
case equations
(2) and (3) collapses to the uncovered interest rate parity condition
r=r"+i
and the financial sector of the model collapses to the money market equilibrium
condition. The main implication of the above equations is that the exchange rate is
determined not just by money market conditions, as in the monetary model, but also
by conditions in bond markets. The novel feature of the portfolio balance model is that
it allows for
and the level of wealth. For instance, an increase in money supply would be expected
to lead eventually to a rise in domestic prices, but a change in prices will affect the net exports and hence
will
.current
payments. This in turn affects the level of wealth which, in adjustment to long-run
equilibrium, feeds back into asset market and hence exchange rate behaviour.
Therefore, the reduced form equation used for estimation purpose is of the form
15
where, b denotes domestic (non-traded) bonds, m denotes the domestic money supply, and CA denotes the cumulated domestic current account balance
(*
stands
for the
foreign variables).
However,
component in the determination of the exchange rate is not unique to the portfolio
balance model. Hooper and Morton (1982), for instance, attempted to incorporate the
are assumed to be correlated with unanticipated shocks to the trade balances. This enabled them
equation.
to
in the
B. Empirical Survev
for the Deutsche mark - U.S. Dollar exchange rate over the period 1920-23. This
period corresponds to the German hyper-inflation. Frankel argued that during the
period of hyperinflation, domestic monetary impulses
will overwhelmingly
dominate
the monetary equation, and thus the domestic income and foreign variables can be
dropped. Frankel reported results supportive of the flexible-price model during this
period. His estimated regression equation is
logs =
+ 0.59llogn
(0.073)
*:
0.994, D.W.
1.91.
l6
The elasticity of the exchange rate with respect to the money stock does not differ
significantly from unity (at 95Yo confidence level) while the elasticity of the spot
exchange rate with respect to forward premium(capturing the expected inflation and
hence, expected depreciation) is positive and significant.
Bilson (1978) tested for the Deutsche Mark - Pound Sterling exchange
rate (with forward premium substituted for the expected change in the exchange rate
and without any restrictions on the coefficients on domestic and foreign money) over
the period January 1972 throttgh April 1979. His results were in accordance with the
monetary approach. Putnam and Woodbttry (1979) estimated the monetary model for
the Sterling - Dollar exchange rate over the period 1972-74, and reported that most
of
the estimated coeflicients were significantly different from zero at 5Yo significance
level.
Frankel (1979) considered the real interest differential model for the mark - dollar exchange rate over the period luly 1974 - Feb.1978. He combined both
the features of the flexible price monetary model and sticky price monetary model to
interest
differential as an instrument for the expected inflation term, on the assumption that
long-term real rates of interest are equalized. He was able to reject both the flexible -
and sticky
differential model. Frankel also tested the possibility that the adjustment in capital
markets to changes in the interest differential is not instantaneous by including lagged
differential is insignificantly less than zero suggesting of the idea that capital is
perfectly mobile.
t7
1973-77 (quarterly data) and reported results largely favourable to the sticky-price
model. The novel feature of this p4per is the incorporation of trade balance responses
to relative price changes in the exchange rate equation. The major findings are
as
follows : (a) the exchange rate overshoots in the quarter in which a monetary change
takes place by a factor of 2; (b) the exchange rate adjustment path to
full equilibrium
However, price adjusts monotonically; and (c) PPP holds in the long-run. Although monetary models performed reasonably well up to 1978, the euphoria was short-lived once the sample period
is
HaSmes and Stone (1981), Frankel (1982) and Backus (198a) cast serious doubts
coefficients were correctly signed; the equations had poor explanatory power
measured problem.
Dornbusch (1980) estimated the flexible price monetary model for the
dollar-mark exchange rate using a quarterly data for the period 1973:2 to 1979:4. The
of Ml,
seasonally adjusted), relative real income (logarithm of gross national product at 1975
1979:4 period
18
s = - 0.03 (m (-0.07)
m.
) -1.05
(y-
y. )+0.01
(i-i
)+0.04
(2.07)
(i-i
(-0.e7)
(1.e0)
1.83.
The above equation offers little support for the monetary model with most of the coefficients being insignificant, and the overall explanatory power of the
equation being very low. The model also suffers from a very high serial correlation
of the
flexible-price
monetary model can be attributed to the breakdown of the PPP in the short run.
it"
differential (RID) model for the period luly 1974 to February 1978 (Frankel's original
sarnple) and from July 1974 to
procedure.
While for the shorter period, all the coefficients have signs supporting RID model,
the situation changes dramatically for the longer sample period. Not only the
coefficient of determination falls drastically from 0.61 to 0.38, the signs of relative
all
monetary models.
Especially disturbing to the monetary approach is the fact that the sign on the relative money is significantly negative rather than positive. This evidence from the longer
sample is similar to estimates of Dornbusch (1980) and Frankel (1982). Frankel called
this phenomenon - the price of mark rising as its supply is increased - the "mystery
the multiplying mark ".
of
In response to this apparent collapse of monetary models, Dornbusch and Frankel each offers modifications. Dornbusch (1980) specifies the current
account as
expectations and portfolio balance models. Frankel (1982) extends the money demand
equation underlying the real interest differential model to include a wealth proxy.
t9
Empirical evidence based upon data extended beyond February 1978 supports the
modifications. Haynes and Stone (1981) have an alternative explanation for the poor performance
of the monetary models. They point out that all the above
equation
in
each
linear constraints are dangerous because linear restrictions, in general, not only yield
biased parameter estimates, but also
it
are positively correlated. Unconstrained estimates show that the model explains the
mark-dollar exchange rate equally well before and after February 1978. Furthermore, evidence
the
Driskill and Shefkin (1981) argued that the poor performance of the
monetary model could be attributed to the simultaneity bias introduced by having the
expected change
in the
of
the
flexible-price model formulation, and found support for the rational expectations
model.
20
-i,)
By assuming that uncovered interest parity and rational expectations hypothesis holds,
the spot exchange equation can be written as
,,
+;k
fi*, - fi*., - fi
,,
,, = k+]-it=l-l't
l+e fi'l+e'
E,lm
*i-
nt*,*j-!,*j+y*,*;)
This equation illustrates the point that exchange rates depend upon
current and expected future values of exogenous variables specified by the monetary model. Thus, changes in the expected value of these variables can result in abrupt
changes
Qa)
(2b)
Qc)
,_r*Fo, Qd)
AR(l) model was
used
to
replace the
appropriate way of estimating the rational expectations monetary model is to estimate equations (1) and (2) as a system to account for the implicit cross-equation parameter
21
restrictions.
to
of
the
to
restrictions implied
considered.
money demand function with a partial adjustment mechanism had more empirical
support than a money demand function mechanism had morye empirical support than a
money demand function which assumed instantaneous stock adjustment. His study covered the time period 1974.3
to
rational expectation hypothesis model was estimated and the restrictions implied by it could not be rejected. Finn (1986) also considered the simple flexible-price monetary model and its rational expectations extensions. The US-UK exchange rate over the
period 1974:5-1982.12. l{rrs result confirms to the rational expectations version of the
flexible price monetary model. The test of coeffrcient restrictions 'could not
be
rejected (at 5Yo significance level) for the REH version, but was strongly rejected for the simple version for the monetary model.
with
nonJinear
constraints. He found support for the Dornbusch model for the period 1973:l to
22
formulated by Buiter and Miller (1981). The model performed satisfactorily, insample.
With the advent of the cointegration methodology there has been a new
fillip to the research in the asset market models of exchange rate determination. The
asset market models are considered as theories
Wallace (1989) tested the monetary model of exchange rate determination as a theory
of long run equilibrium. They used the Engle-Granger (1987) two-step cointegration
methodology to test for the presence of co-integration among the variables of the
of
for
five
industrialised countries - U.k., Japan, Germany, France, and Canada - the U.S. Test
and estimations employed monthly data covering the period of floating exchange rates
beginning
in April
1973
commenced floating in July 1970, and June T972, respectively, and upto the end
of
1986. Their results were generally unfavourable to the monetary approach both in the
case of restricted model (which assumes equality
unrestricted model. Only the restricted model for France with U.S. as base country
supports the hypothesis of cointegration.
Given the problems with the Engle-Granger test, the above result was
not surprising. MacDonald and Taylor (1991) used the multivariate cointegration
technique proposed
by
relationship between monetary variables and the exchange rate. They also considered
four of the five countries in the McNown and Wallace study, namely, Germany, U.S.,
Japan, and
U.K. Their study covers the time period January 1976 to December
1990.
They took
Ml
term rate given in IMF's International Financial Statistics. The money supply and
23
industrial production series are seasonally adjusted. Two interesting results stemmed
from their work. First, the presence of cointegrating vectors provided a valid
explanation of the long-run nominal exchange rate. Two, for the German Mark - US
Dollar rate,
a number
MacDonald and Taylor (1993) used the data for the deutsche mark U.S. dollar exchange rate over the period January 1976 to December 1990. Their major empirical findings are as follows. First, the static monetary approach to the
exchange rate determination has got some validity when considered as a long-run
equilibriurh condition. Secondly, when the exchange rate fundamentals suggested by the monetary model are assumed, the speculative bubble hypothesis is rejected and
thirdly, the full set of rational expectations restrictions imposed by forward looking
monetary model are rejected. However, their testing procedure
of the rational
expectation version of the monetary model is different from the earlier tests of the
forward looking solution relies on the multivariate cointegration methodology and its
application to present value models. The forward looking solution of the flexible-price monetary model can be written as
s, = (t +A)'Zrhr' E(*,*,t1,)
where,
x,=lm' *f y'f,.
This is the basic equation of the forwardJooking monetary approach to the exchange
rate @MAER). An implication of the present value model of the exchange rate is that the exchange rate should be cointegrated with forcing variables contained
i, 4
24
u /(0)
Finn (1986)) implemented the present value exchange rte model in first-difference
form. However, as Engle and Granger (1987) pointed out that
if a vector of variables
are cointegrated, then an empirical formulation in first difference misspecifies the data
if
Campbell and Shiller (1987) to test the forward restrictions. We first need to estimate a VAR of lag length p for the vector
g = lA^xr,....,...,A x
t_
p+t,
L r,.....,L,_ o*rl
Define
g'
and
h' as selection vectors with unity in the (p+l)th and first elements
respectively, so that,
Lr=g/2,
(2) (3)
and
Lx,=h/r,
Elr,*rlH ,)= Ak z,
where, .F/
(4)
of
L,
and
Ar,.
st
- xt = ,i t*l,E(Lx,,tlIt)
Projecting both sides onto .F/, and using (2), (3), and (a) we obtain,
8t
z,
,,
25
M,)'
A
Ho : gl (I
WA)
- h' ryA -
Li = h' VA(I *
ryA)-t zt
is
tantamount
to testing H , . L,=t ,.
Manifest
I,
and
lr
would be indicative of
as suggested by the monetary approach. They limit their analysis to India, Pakistan
and Sri Lanka and worked with the annual data. They estimated an equation of the
form
so = ao * or,so + az(m
where,
- m*) + at(y -
y-) + aa(r
- r*)
s, is the black market exchange rate, s o is the offrcial spot exchange rate.
The oflicial exchange rate is included because the black market exchange rate is
dependent on the official exchange rate and the administration of the official market.
exchange rate (the spillover effect) and the monetary variables (the underlying shifts
in
in a
for
the
monetary model using Johansen cointegration methodology. For each country the
26
model with no trend was rejected. For India the cointegrating vector, when
normalised on
s,
is obtained as
of the monetary model : Frenkel-Bilson, Dornbusch-Frankel, and Hooper-Morton. In all the three models only one cointegrating vector is detected which suggest that the
long-run relationship exists for the US dollar
models of the exchange rate (MMER) during the German hyperinflation period
1920s. The purpose of this paper is to derive and test the cointegration implications
of
of
Frenkel's (1976) model. Also, based on the cointegration result, he derives and test
the exact restrictions that the rational expectations imposes on a bivariate monetary
model
for
of
multi-
cointegration to test for the restrictions imposed by the rational expectations version
of the monetary model. Despite the very strong assumptions inherent in the model,
viz,
accurate
hyperinflation period.
to
of the monetary
model
of
exchange rate
All
seasonally unadjusted. The money stock variable used for both countries is
Ml,
the
long term interest rate is represented by the long-term government bond rate, and the
27
industrial production is used as a proxy for income. The exchange rate is expressed
as
Canadian dollar per US dollar. The ADF tests are applied with monthly seasonal dummies turning out to be I(1).
coefficients conform to the restrictions imposed by the monetary model (only the proportionality relationship between money supply and exchange rate
is
getting
rejected) which lends support to the interpretation of the model as describing a long-
run equilibrium relationship. This support is reinforced by the results derived from the associated error-colrection model, which identify
short-run tendency
for
the
exchange rate to revert to the equilibrium value defined by the estimated long-run
model.
monthly data from January 1976 toMay 1994 for the Deutschemark - Dollar, Dollar-
the presence of I(2) and I(1) components in a multivariate context. Two cointegrating
vectors are identified for all cases by using the maximum eignvalue test statistic. To
identify the two cointegrating vectors, independent linear restrictions on each vector
was imposed. Some commonly imposed restrictions on the monetary model were used
for one vector while the other was restricted to provide the Uncovered Interest Parity
relationship. However, the Likelihood Ratio test rejected all the jointly imposed
restriction and they were unable to associate the forward-looking version of monetary
model with either vector, conditional upon the other describing the Uncovered Interest Parrty condition. This outcome may be attributed to the failure of the UIP condition to
hold in the long run. However, the unconditional version of the monetary model to the
28
exchange rate may still be a valid framework for interpreting the long-run movements
model may have very good in-sample properties like high adjusted squared
if it performs
poorly in this
respect, then one may have to reduce his/her confidence on the model.
till 1978-
79. These models, when tested on the extended time period covering upto early 80s,
also performed well in-sample, albeit after some modifications (see Dornbusch
(1980), Frankel (1982). However, the picture is totally different when one considers
the out-of-sample forecasting performance of these models. Meese and Rogoff (1983) compares time series and structural models
of exchange
Each
competing model is used to generate forecasts at one to twelve month horizons for the
rolling
this methodology, the parameters of each model are estimaed on the basis of the most up-to-date information available at the time
29
variety of univariate time series techniques are also applied to the data. They also
considered an unconstrained vector autoregressive
equation (I).
which the contemporaneous values of each variable is regressed against lagged values
of itself and all other variables. For example, the exchange rate equation is given by
s
ai1
s .-t+ ........... +
a in
s t-n
B'
- r * .......... + B' i, X - n *
u'tit
where, Xit =
{* rm* rlr!
rfr
rT* , rfr'
,fr"
,TBTTB
*)
and
cumulated trade balances to have same coefficients. The VAR model is important
because
robust to estimation problems like simultaneous equation bias, which plagues the
above discussed structural models.
Each model is initially estimated for each exchange rate using data up through the first forecasting period, November 1976. As mentioned already, forecasts are generated at one, three, six and twelve month horizons. The purpose
of
considering multiple forecast horizons is to see whether the structural models do better than time series models in the long run, when adjustment due to lags and / or serially correlated error term has taken place. It is expected that when lags and serial correlation are fully incorporated into the structural models, a consistently estimated
will
in large
Mean Error
(ME), Mean Absolute Error (MAE) and Root Mean Square Error (RMSE). Table
below gives the RMSE for the US dollar / pound sterling exchange rate at one, six and
30
twelve month horizons over the November 1976 through June 1981 forecasting period
Forward
Rate 2.67 7.23 11.62
Univariate
Autoregression 2.79
7.27 13.35
VAR
Frenkel
DornbuschFrankel
2.90 8.88
Hooper-
Walk
$/pound
-Bilson
s.56
2.82 8.90
Morton
3.03
Month
2 Month 3 Month
t2.97
21.28
9.08
L4.J I
t4.62
t3.66
The above table is a representative of the general results obtained by Meese and
Rogoff. None of the models achieves lower, much less significantly lower, RMSE
than the random walk model at any forecasting horizon. The structural models, in
particular, failed to improve over the random walk model in spite of the fact their
forecasts are based on realised values
separate coefficients
there could be problems with respect to the building blocks of the structural exchange
rate models : uncovered interest parity, proxies for inflationary expectations, goods market specifications, and the common money demand specification.
A lot of research
Rogoff. As discussed earlier, Woo (1985) and Finn (1986) estimated the rational
expectations version of the flexible-price model. Woo (1985) argued that a money demand function with a partial adjustment mechanism had a more empirical support
Following Goldfeld (1973), they included a lagged money term in the money demand
specification to capture the partial adjustment in money holdings. The study focused
of-sample forecast comparison with the random walk model. The result showed that the rational expectation version of the monetary model outperform the random walk model at every forecasting horizon under the mean-absolute-error criteria. In terms
of
root- mean-square-effor also, the structural model outperform the random walk
model.
to
1982:12
exchange rate. The forecasting period embraces 1980:1 through 1982:12 and the forecasting performance
is
of
the
monetary and the random walk models. In terms of root-mean-square-effor and meanabsolute-error, the two models are very closely ranked for the one- and six-month forecasts
horizon and rational expectations monetary model marginally better at the six-month horizon. For the twelve month horizon forecasts, both models are closely ranked
the
and better
criterion. In light of the above results, Finn concluded that the rational expectation
monetary models forecasts as well as the random walk model.
32
of
models reported by the Meese and Rogoff (MR) without imposing the restriction that the regression slopes are fixed over time. Major result of their study is that when all
coefficients are allowed to vary, the conventional models of exchange rates employed
by MR yielded more accurate forecasts than their fixed coefficient counterparts and
more accurate than the random walk models. The study, however, supported most
of
the MR conclusions regarding fixed coefficient models, but contrary to the MR study,
in the forecasts of
fixed
coefficient models that include lagged adjustment. The structural models estimated by
MR and used for forecasting nominal spot exchange rates (do11ar-mark, dollar-yen,
Bz(yt-y.)* Bz(r,-r.,)+
p+(tTt"
-v,". )+ Bs(TBt-T?.,)+u,
of fixed
coefficient regressions (that is,'rolling regression') is not the appropriate technique for capturing the variations in coefficients overtime. At the high level of aggregation
of
exchange markets, there is little reason to believe that behavioural parameters are
fixed. There is a wide diversity of participants in foreign exchange rate markets with relatively small and highly variable market shares. Even if each participant reacted to macroeconomic developments according function,
to a
it is difficult to argue
exchange rates by a simple fixed coefficient relationship, without also assuming that
&=Q tt*vt
E(vt) = Q
E(vtv") = Ao if Fs
where,
and 0, otherwise.
xt,Bt,B,tt,vt
are
all (kxl)
logarithm of the spot exchange rate. In (3), each coefficient in each period, B i, , has
and
a time-dependent
Combining (2), (3) and (4a), we can view the stochastic coefficient representation as a
fixed coefficient model with effors that are both serially correlated
heteroscedastic, where the form general
:
and
1981.
The competing models include, apart from the stochastic coefficient model, fixed
coefficient model, and random walk model. The stochastic coefficient model turn out
34
to produce superior forecasts than the fixed coefficient model and also outperformed the random walk model. They also generated multistep-ahead forecasts of the Box-
these papers
exploited the long-run and short-run properties of the monetary models to generate out-of-sample forecast that outperformed the random walk in terms of RMSE and
to those
generated
by a random walk
of
forecasting model. They found for the deutschemark-dollar exchange rate existence
if a cointegration
relationship exists among a set of I(1) series then a dynamic error-conection of the data also exists. So they estimated the error-correction model for the initial period
1976:l to 1988:12 and reserved the last 24 datapoints, corresponding to the period
1989:01 through 1990:12 for post-sample forecasting performance. They performed a d5mamic forecasting exercise
elror-correction model outperforms the random walk model at every forecast horizon
as shown in the table below
:
35
RMSE from
Model
0.148 O.TI2 0.088
RandomWalk
t2
9 6 J 2
1
0.043
0.032
0.028
Note : Figures are logarithmic differences and are therefo re approx y equal approximatelv equa to
percentage differences divided
by
100.
This shows that imposing the monetary model as a long-run equilibrium condition on
correction version
forecasts for the Australian dollar vis-d-vis the US dollar in terms of root mean square
error (RMSE) of forecasts. For estimation quarterly data from 1976Q1 to 1990Q1 has
been used. The period 1990Q2 to 1991Q1 has been used for ex post prediction. Five
/ BVAR
balance, three month forward rate, relative long-term interest rate, and relative price
level. The BVAR model was estimated with several degrees of tightness
(2),
decay
)":0.I,0.25,0.3; d:1,2;w:0.01,0.15. A
structural model (due to Wallis(1989)) was also constructed to compare its forecasting
36
perfoflnance with the multivariate time series model. It was found that the structural
model performs best in terms of RMSE than either of the two time-series models.
BVAR model performs better than the unreskicted VAR, but not as well as the
structural model. An attempt was also made to improve the forecasting performance
Liu, Gerlow and Irwin (1994) analyses the forecasting accuracy of fuIl
vector autoregressive (FVAR), mixed vector autoregressive (MVAR) and Bayesian
vector autoregressive (BVAR) models of the US dollar lYen, US dollar
I Canadiart
dollar, and US dollar / Deutsche mark exchange rates. The VAR models are based on
the theoretical model of monetary
by
Driskill et.al (1992). The models are estimated over the in-sample period L973:3 1982:12. For the out-of-sample period covering 1983:1 through 1989:12,
informational content tests, and market timing ability tests. The variables included in
the model are logarithm of the exchange rate, logarithm of
the logarithm of relative price levels, the interest rate differential and the trade balance
to
estimate the
MVAR. To determine if the forecasts generated from the alternative VAR models
37
test developed by Fair and Shiller (1989, 1990) was employed. In the case of the US
dollar
I Yen exchange
of 1- through 6-months,
forecasts
generated
by the FVAR, MVAR, and BVAR models did not contain additional
information beyond that produced by the random walk forecasts. However, the BVAR
model dominated the FVAR and MVAR at the l2-month forecast horizon, and it
contained additional information not generally not found in a random walk model. In
terms of market timing ability test, the forecasts generated from the FVAR models,
for all three exchange rates, have no significant market timing value. In other words,
the FVAR model is not capable of significant predictions of the directional movement
all
forecast horizons
Forecasts generated from a BVAR model also have significant market timing value
I Catadian dollar
forecasts horizons. Thus, out-of-sample forecasting performance indicate that the forecasting performance
Benjamin and
multivariate cointegrating
methodology to generate long-run forecasts of the US dollar / Deutschmark exchange rate.' They used three competing structural models
- Frenkel-Bilson, Dombusch-
and
vector was detected, suggesting that the long-run cointegrating relationship exists
between the exchange rate and economic fundamentals. They initially estimated the
- 1988:07
forecasts were evaluated in terms of RMSE and MAE statistics. The forecasts were
38
from the structural model clearly outperformed the random walk model at every step.
This finding was especially significant in that the multistep-ahead forecasts of the
structural models outperformed even the one-step-ahead forecasts of the random walk model.
techniques. They examined four bilateral rates (Canada, Germany, Japan, and the
U.K.) relative to the US dollar, using monthly data for the period 1973:03 - 1990:11.
They argued that the post-Bretton Woods era was too short to extract reliable
estimates
of
coefficient
restrictions for each of the candidate models and used them to generate the errorcorrection term.
by OLS
and
instrumental variables (IV) procedures in unconstrained first differences, and error correction models.
At
discouraging result compared to the naiVe random walk model (with or without drift)
performance
Bhawani and Kadiyala (1997) employed the black market data for
exchange rates
in
of
several exchange rate models. Unlike other studies which used the ' actual
' realized
39
values of the exogenous variables, this study employed expected future values of the
exogenous variables (predicted outside the model). As representatives of the structural
for
Bilson-Frenkel
flexible price model and sticky price Dornbusch model. They also estimated an efforcorrection version of the structural models.
The models have been used to generate forecasts at one, three, six and
twelve month forecast horizon for the Indian rupee / US dollar, Mexican peso / US dollar, and Pakistan rupee / US dollar bilateral spot exchange rates. Forecasts for all
models are based on rolling regressions. Initial sample period for India covers the
period 1913-89, for Mexico it covers 1982-89 and for Pakistan it covers 1978-88. The
correction version of the Bilson-Frenkel model outperformed the simple random walk model at all forecast horizon for the Indian rupee / US dollar exchange rate. While in
case
of Pakistan the effor-coffection model outperforms the random walk model at all
forecast horizon, except the one-month forecast horizon, for Mexico peso / US dollar
the simple random walk model exhibits the least forecast error at all horizons,
followed by the effor-coffection model. Choudhry and Lawler (1997) estimated an eror-correction version
of
the monetary model for the Canadian dollar - US dollar exchange rate over the period
of the Canadian float 1950-62. To test the adequacy of the monetary error-correction
model a forecasting exercise was carried out. Forecasts are generated for three, six,
nine, and twelve month forecasting horizon over the period June 1961 to May 1962. For the comparison purpose forecasts were also made with two alternative models - a simple random walk model and a random walk model with drift. RMSE statistic has
40
been used for evaluating the forecasting performance. The error-corection model
outperforms both the random walk models across the range of forecast horizons.
soon after the breakdown of the Bretton Woods Agreement. More specifically, the
monetary models performed well in the years 1975-T980. (Frankel (1976), Bilson
(1
few modifications to the original structure were put forward. (Dornbusch (1980),
Frenkel (1982), Haynes and Stone (1981), Driskill (1981).
of
the monetary
autoregression formulation
rate
determination produced forecasts which beats the random walk forecasts, mostly
in the developed
&
41
Chapter
III
OLOGY
of
various forecast evaluation measures. Starting point of any time series analysis
involves checking of the stationarity properties of the series under study. This is
achieved by the traditional unit root tests of (Augmented) Dickey-Fuller test (ADF),
Phillips-Perron (PP) test as well as two other test of unit root - KPSS Test, which is essentially a non-parametric tests and Bayesian unit root test. Various unit root tests
are performed to get a clear picture about the presence
in more detail in
section
A.
Section
discusses the
(VAR) models
as
proposed by Sims (1980). This includes full VAR (FVAR), vector error correction model (VECM) and Bayesian VAR (BVAR).
Section A
econometric literature since the seminal work of Nelson and Plossar (1982). A nonstationary series has the following properties
:
42
(a) There is no long-run mean to which the series returns. (b) The variance is time-dependent and goes to infinity Unit root becomes important in the context
as
spurious
without any economic meaning. So it is very important to find out the stochastic
properties of . the variables under study so that we do not ran into such spurious
regression problems.
In the first modern attempt to test for the unit roots, Nelson and Plossar (1982) tested 14 historical macroeconomic time series for the US by the Augmented
Dickey-Fuller (ADF) test. They analyzed the logarithms of all of these series (except
for the interest rates, which was treated in levels) and found empirical evidence to
support a unit root for 13 of them (exception being the unemployment rate). Meese and Singleton (1982) studied various exchange rate time series and could not reject the null hypothesis of a unit root. In the present thesis, we work out the sequential
+ \fiLyni+t * tt
p
(1)
atlt-t +
(2)
Et
arlrt
azt +
f,^
fri L)tri+t I
(3)
43
i}t
:0.
The first equation is a pure random walk model, the second add an intercept or drift term, and the third includes both a drift and linear time trend. Enders (1995) suggests a sequential testing procedure to test for the
presence of a unit root when the form of the true data generating process (DGP) is
unknown. The motivation of doing this sequential procedure can be traced to Cambell
and Perron (1991). They pointed out that the major problem with the Dickey-Fuller
(DF) test is that tests for a unit root is conditional on the presence of the deterministic
regressors and tests for the presence of the deterministic regressors are conditional on the presence of a unit root. This follows from the fact that
includes deterministic regressors that are not in the actual DGP, the power of the unit
a deterministic
trending variable present in the true DGP, such as azt, the power of the t-test goes to
zero as the sample size increases. This necessitates the following sequential testing procedure ofunit root. Step 1. (ar Estimate the most general model (eq.(3)) and test the null of unit root
the null is rejected, conclude that unit root is not present
0) by s statistic. If
in
in the eq.(3). This is achieved by testing the significance of the trend term under the null of unit root by using e B, statistic or Q. statistic. If the trend is not significant
we proceed to step 3. On the other hand, if the trend is significant we go back to step
44
1 and retest
for the presence of unit root using the standardized normal distribution.
If
the null of unit root is rejected stop the sequential procedure and conclude that the
series is stationary. step 3.
Step 3.
Estimate equation (2), that is, one without a trend but a drift (constant)
ustatistic.
is rejected conclude that the series does not contain a unit root and stop the sequential procedure. Ifnot, then proceed to step 4. Step 4. Here we determine whether a drift term is needed to be included in our
,,
statisti c
or
Q , statistic.
If the drift
term
is not significant proceed to step 5. If, on the other hand, it is significant, we return to
step 3 and retest the null of unit root by using the standard normal distribution.
Rejection of null of unit root
will
conclude that the series does not contain a unit root. Non-rejection of the null
lead us to step 5.
will
Step 5.
Finally, we estimate the simple model, that is, one without a drift or
trend term (eq.(l)).We use the g statistic to test for the presence of unit root.
If
the
45
!r=a
o*a r!,q*ll,
(1)
lt
where T
= do *
drla
+ d2(t
Tl2) +
1t1
(2)
No. of observations.
:
a r =l
Z(td):
dr = 1.
if
rejected by the DF test but rejected by the PP test, then we rely on the PP test and conclude that the series does not contain a unit root.
(iii)
KPSS Test:
make the unit root the null hypothesis and given the low power of the former test it is
very difficult to reject the null of unit root. KPSS, therefore, argue that in trying to
distinguish between stochastic and deterministic trends,
the null of trend stationary and difference stationary. They developed a test of unit root where null hypothesis is taken to be the absence of unit root. This is essentially a
non-parametric test.
Let
Y1
and
Yt = (.t *rt*tt
Here
11
follows
a random
walk.
46
Let
e1
trend.
"
be the estimate of the error variance from this regression (the sum
:
of
squared residuals divided by T). Define the partial sum process of the residuals
s' =
,E,
u'
,r:
lrzr.....rT.
LM
=\5,
i=1
,I 6,
^s21/1
Y"
non-negativity of the estimated sample variance. The lag parameter for residual serial correlation.
t=
!,-y),
tail
how probable is null of unit root relative to the other competing hypotheses. The
classical econometricians cannot give the probability that a hypothesis holds. What
47
they can tell us is whether a hypothesis is rejected or not rejected (Koops, 1992).
Further, while the classical inference is sharply affected by the presence of a trend and
lt=Pit-t*8t
The test statistic is the square of the conventional rstatistics for P =
t.
This is
bg (oil + 2tog(t
- 2 tts1
12.
o'
o'
o=
v,G
*r)' , o'
is the variance
" Alpha" gives the prior probability on the stationary part of the prior; the remaining
probability is concentrated on p = 1
root.
If
t2 >
of
univariate time series. This is found to generate forecast which is as good as, if not
of
autoregressive integrated
moving average (ARIMA) models is the relatively little information set used in
estimation and forecasting
p is the order of
the
48
o@)0-B)"
, = O(B)u ,+6
where, the polSmomials in the backward operator (B) are given as follows
B'
e@)
In the identification
series, autocorrelation function, and partial autocorrelation function. We use the tests
of
the
and
commonly used model selection criteria are the Akaike Information Criterion (AIC)
and Schwartz Bayesian Criterion (SBC)
:
n: T:
Ideally, the AIC and SBC should be as small possible. Of the two criteria, the SBC
has superior large sample properties. The serial correlation test is performed by using the Lung-Box-Pierce Q statistic
LQ=n(n+rZ*
49
serial
'
checking. Here, we primarily see whether the residuals from an estimated model are
of
a systematic
movement in the series that is not accounted for by the ARMA coefficients included
in the model. The Ljung-Box Q statistics of the residuals are used to test the presence ofserial autocorrelation in the residuals.
Finally, we can use the selected model to obtain the forecast of the
series.
of a
serious empirical
of
dependent variable and the explanatory variables in a time-series regression are non-
combined with a low Durbin-Watson statistic. These synrptoms are familiar features
of estimated exchange rate models [Boothe and Glassman (1987)]. This led to the
concept
presence
the
whether the non-stationary variables have any meaningful relation among them.
50
Yt=00+8121+e1
The estimated residuals are saved.
If
found to be stationary, the Yl and 21 series are cointegrated of the order (1,1). So in the
second stage, we perform the unit root tests stationarity of the estimated residuals.
requires that the researcher place one variable on the left-hand side and use the others
as regressors. So,
Moreover,
cointegrating vector
among the variables. For all these drawbacks, it is suggested to test for the presence
of
cointegration among the variables in a multi-variate framework by using JohansenJuselius Maximum likelihood method (JD (1990).
!
where
,=
At!
,_t*......+A
*!
rtc+Y.D+e
stochastic variables,
D is a vector of
nonstochastic
variables, such as seasonal dummies or time trend. Johansen test assumes that the
51
variables
in y ,
are
I(l).
Ly , = f , A.y,-, *.......tf
o-,
H
where a and p are
,:fI - o0'
implies that the
relations
process
formulation
which allows for the inclusion of both differences and levels in the same model
thereby allowing one to investigate both short-run and long-run effects in the data.
The number
of
number
of
= -, ,Jr - -T
ln (1 -
;*l)
In (1-,tr,+l)
,',
II
matrix;
T is the number of
usable
Section D
52
restrictions and lag structures are imposed on the data-generating process. VAR
allows the data to speak for itself by allowing data to determine the lag structure and
doing away with the arbitrary exogeneity assumption that the structural econometric models often make. Moreover, estimation of VAR becomes very important in the
context of multivariate cointegration tests proposed by Johansen-Juselius. Consider a pth order VAR of n variables
!t
Ao+At!,_tl
.......+A p!,_p+e
and
,is
an (nx1) vector of error terms. VAR modeling has been popularrzed due to
Sims (1980). The variables included in the VAR are selected according to the relevant
economic model. VAR model scores over the traditional structural modeling by
endogeneity
of the variables
under
consideration. Rather, it treats all the variables symmetrically. When all the variables
included in the VAR have the same lag length in each of the equation of the VAR
system then
it is known
as a
FUIMR
lag lengths for each variable in each equation. Such a system is called Mixed VAR
(MVAR). If some of the VAR equations have regressors not included in the
seemingly unrelated regressions (SUR) provide efficient estimates
coefficients.
others,
of the VAR
The choice of the lag length in VAR is an important issue, as the inclusion of unnecessary lags
will
inclusion of lags quickly consumes the degrees of freedom. . The two commonly used
measures are the multivariate generahzation of the
53
AIC=Tlogl2l+2
SBC
= rlog lll
+ Nlog (7)
where, l>l is tfre determinant of the variance / covariance matrix of the residuals; N is
the total number of parameters estimated in all equations. The model based on the
lowest AIC and SBC is chosen.
Another test that is often employed for selecting the lag length is the
X,
and
X,
be the variance
unrestricted and restricted system respectively. Asymptotically, the test statistic is given as
LR =
e-c)(
tog
of
freedom equal
to the number of
logll,l
If
statistics exceeds the tabulated critical value, we reject null hypothesis, i.e., we reject the restriction.
variable z should be there in the system is similar to testing whether lags of z in x and
y equations
likelihood ratio test. For this we need to estimate the x and y equations using p lagged
values of x,
covaiance matrix X ,
of z
54
Q-c)(
log
lX.l
log l>,1)
X'
lagged
of
z.
both the short-run and long-run dynamics which may significantly improve the
model's forecasting performance. Consider the two variable system with the two variables. The two variables are integrated of order
and zberng
cointegrated, that is, there exists a linear combination among them which is an I(0)
variable. Given this one can estimate the error-correction model of the following form
yt
Lz , = F ,+ 0
where O,-r=
!,-r-fr
p,
as
below
,
if
of
55
of the eror-coffection model is only one of the approach to the problem and is
certainly does not exhaust the literature. The early development of the error-correction
model was very much the work of the London School of Economics by Phillips, Sargan and Hendry. Phillips (1954,1957) introduced. the terminology
of
error
correction
to
economics
in his
analysis
of
(1978) on aggregate time series relationship between consumer's expenditure and income , proved to be a very important cornerstone. Work by Engle and Granger
(1987) on the effor-corection model is different because they take into consideration
the cointegration property of the time series data.
forecasting
is an art,
models, but also the forecaster's personal beliefs about how the economy behaves.
The Bayesian approach to statistics, a general method for combining beliefs and data
has
been developed explicitly along Bayesian lines, provide modelers more flexibility in expressing their beliefs as well as an objective way to combine those beliefs with
historical data.
56
future values of a vector of variables to past values of that vector. From Bayesian
point of view, UVAR models allows the data speak for themselves. This implies
complete ignorance on the part of the modeler regarding the value of the coefficients
included in the UBVAR. The forecasting problems of large UVAR models stem from the fact that economists often have too little data to isolate in a model's coefficients
only the stable and dependable relationships among its variables which leads to poor
forecasting performance.
are
widely used for economic forecasting, overfitting problem of the UVAR model is
tackled by including in each equation of the model only a few variables (or lags
of
variables) that economic theory suggests are most directly related to the variable that
overfitting in a structural model, they are often too rigid to accurately express the
modeler's true beliefs and tend to cause useful information in the historical data to be
ignored.
as
in both types
of models each variable is allowed to depend on the current and past values of all the
variables included in the model. But at the same time
model and resemble a structural econometric model by using prior beliefs to reduce overfitting. However, the sources of the prior beliefs and the ways they are used are
generally different in a BVAR model than in a structural model. Whereas economic theory is the main source of prior beliefs, a BVAR to guess which values of all the
57
coefficients
will
Building s BVAR:
The first step is to construct an unrestricted VAR model. A n-variable
x(t)+u(t),
1,2,........, T.
(nkxl)
vector of coefficients on
xl)
is an
(nxn)
on
is
zero fot
of
of y appear on the
y(i,t)
j,c) y(j,t - j)
x'
1t1B1i) + u(i,t)
where,
y(i,t)
and
u(i,t)
are the
of B
normal prior distributions for each of the nz m YARcoefficients, such that a(i,
j,r)
j,c)
and variance
s'(i, j,r).
58
r)
Q,
j,c)
confidence in that guess (smaller values reflecting greater confidence). The Minnesota
prior is the most often used prior which takes into account the fact that many
economic time series follows a random walk. The Minnesota prior means are given by
5(i,i,r1=1
,f i=
-0
otherwise
The Minnesota prior simplifies the choice of values for the s(i,
s(i,
j,r)
=ly sG)f(i,
j)l(.{i)
sj
(4)
y(i,t), y
is the
g(r)
(i,j)
variable in the ith equation relative to the ith variable. Since the variables in the model
j,
tt
included as a rescaling factor to make units comparable. Equation (4) reduces the number of prior variandes fuom nzm
thought of as the i,
assume a symmetric
to n2+2
parameters. Each
f (i,j)can
be
jth
element of an
must be specified. We
prior for
(i,
j)
f (i,j)=t if i=i
=w otherwise
59
n2
gives the relative tightness on the coefficients of the ' other ' variables in the ith
equation.
reflects the increasing confidence that coefficients are close to zero as the length
the lag increases. Two possible functions are possible
Harmonic
Geometric
In both
cases, the single decay parameter, d, must be chosen. For the harmonic
function, the choice of a larger d implies more rapidly increasing tightness and thus a
more rapidly decreasing s(i,
j ,c)
the choice of a smaller value of d implies more rapidly increasing tightness. The
overall parameter, y, gives an overall measure of confidence in the prior, with smaller
values coresponding to greater confidence.
60
for judging the forecast performance of the competing models. This is essential to
determine the qualitative performance of the forecasts. Moreover, it has been noticed
from the various empirical works that the ranking of the forecasts change quite
substantially under altemative forecast evaluation criterion. Given this fact it may be
upto the forecaster to give subjective weights to the alternative forecast evaluation criterion to na:row down to one particular forecasting model. Again, the alternative
criterion may give very rankings to the forecasts from the various models at different
forecast horizons. So one may, in practice, find different models producing the best forecast at different forecasts horizon.
L(Y ,*tr,t ,*,,,,), often restricted to L(e,*0,,), which charts the "loss", "cost" or
"disutility" associated with various pairs of forecasts and realizations. Here the k-period ahead forecast errors and
e *k,t
,*0., is
forecast effors. In addition to the shape of the loss function, the forecast horizon (k) is also crucial importance. Rankings of forecast accuracy may be very different across
different loss functions and / or different horizons. This result has led some to argue the virtues of various
"
universally applicable
" accuracy
6t
Hendry (1993), for example, argue for an accuracy measure under which forecast
rankings are invariant to certain transformations. Nevertheless, let us discuss a few stylized statistical'loss functions,
because they are
, or percent
errors,
(Y
,*r,
-t
,*0,,)
lY ,*r,.
Root Mean Squared Error (RMSE) and Root Mean Squared Percent Error (RMSPE)
defined below
:
RMSE=ff*,,
RMSPE =
**o
+*l
,.r)
Two other forecast accuracy statistics that have appeared in the literature are (1) Mean Absolute Error
MAE =
: MA\E =
lLl,
,.r,,1
Anyway, the above measures do not provide much direct information about whether something better might be achieved common
in terms of
forecasting.
It is
to
U2=
t=1
62
U2:0
U2
model, that is, the model should not be used for forecasting. IJ2 >
I implies
of
it is essential to
"rro..
unbiased estimates of the actual series. In the present context it means that bias test determine
if
implies that forecasts are consistent in the sense that forecasters are not systematically
mistaken their forecast.
Tests ofunbiasedness are based on a regression
ofthe form
A,*n:d+BP *h*
The joint hypothesis
t+h
(1)
unbiasedness.
a=0
and B
=1 entails
if
p,
associated with the above regression is that serial correlation is introduced into the
error term for equations corresponding to 3 -, 6-, 9-, and 12-month ahead forecasts.
For h
exceed the
63
sampling frequency (assumed to be 1), so that forecasts overlap in the sense that they
in the previous
rationality does not rule out serial correlation in the error process of
moving average
seems
error term. To correct for these problems, a heteroscedastic, autocorrelation consistent covariance matrix (Newey and West (1987) is used to estimate the standard errors
of
coefficients in the above equation. With the use of the Newey-West estimator, the
as a Chi-squared.
If
there is a systematic
relationship between the two, then this could be exploited to help predict future errors,
and could be used to adjust the forecast-generating mechanism accordingly. Mincer
and Zarnowitz (1969) used the concept of efficiency in this sense. They define
forecast efficiency as the condition that p
=l
When the data are non-stationary, integrated series, then a natural further requirement of the relationship between the actual and forecasts is that they
are cointegrated. Infact, Cheung and Chinn (1998) proposed a test of rationality
based on the time series properties of the actual and the predicted series : the forecast
and the actual series (a) have the same order of integration, (b) are cointegrated and
(3) have a cointegrating vector consistent with long run unitary elasticity of
expectations. This means that cointegrating vector involving actual and the predicted
series should be (1
-1).
64
Hendry and Clements (1998) argued that the above tests of unbiasednsess or
rationality.may be too slack in that they are satisfied by more than one predictor, or
conversely, too stringent given the typical non-optimality of most forecasts, stemming
of
ifonly
of unbiasedness
rest on strong statistical assumptions. Unsystematic forecast errors need not have
fixed variance through the sample period, nor need they be normally distributed. Such
of
the
regression statistic. Moreover, standard testing procedures associated in (1) are only
valid as5rmptotically when the disturbances are correlated with future values of the
regressors. To deal with these problems, Campbell and Ghysets (1995) introduced a nonparametric testing methodology to assess the unbiasedness of forecasts. The focus
of this nonparametric approach is on the median of the forecast effors rather than the
mean. However, for symmetric distributions with finite mean, median-unbiasedness
and mean-unbiasedness are equivalent. Nonparametric tests may be more reliable than
E ir=Sr-s"
r-,
65
Define a function
u(z)=1if z>0
= 0 , otherwise
The role of the u (z) function is simply to indicate whether the forecast error is
positive or negative.
Consider the signed test statistic
:
st
where
Z"@ t=l
u)
t:|,2,......,T
Under the null hypothesis that the forecast errors are independent with zero median,
the sign statistic is distributed with
with the number of trials T and probability of success 0.5. In large samples, the
studentized version of the statistic is standard normal,
s
lr
distributions.
symmetry.
,-T l2 /4
N(0,1)
of binomial or
normal
It
should be noted that the sign test does not require distributional
w , =2"@,, )'R*
t=l
,,
where R*
order.
,,
is the rank
of
lE ,,1 with lE
,,1,.
Under the null hypothesis that forecast errors are independent and symmetric about
mean zero (and hence about azero median), W
rank test. The intuition of the test is that if the underlying distribution is symmetric
66
about zero, a "very large" (or "very small") sum of the ranks of the absolute values
the positive observations is "very unlikely" to be high. The exact finite-sample
of
distribution of the signed-rank statistic is free from nuisance parameterS and invariant to the true underlying distribution. Moreover, in large samples, the studentized version of the statistic is standard normal,
*,-ryP
r (T +DQr +D
N(0,1)
The results from the bias test will enable us to tell whether forecasts are unbiased
predeictors of the actual exchange rate.
it may be actually
biased.
Then it may be difficult to tell unambiguously whether we should use those forecasts
even when they are beating the random walk.
III.
of
relatively small errors than another. This does not any way tell us whether the
difference in the MSE or RMSE between the competing the forecasting models is
significant or not. So one may get a lower MSE or RMSE compared to the simple
random walk model but that difference may not be statistically significant. So
it
is
very essential to find out whether the difference in the MSE or RMSE arising
statistically significant or not.
are
no difference in the accuracy of two competing forecasts which allow for forecast
67
effors that are potentially non-Gaussian, non-zero mean, serially correlated, and
contemporaneously correlated. Suppose that a pair of h-steps ahead forecasts have
produced errors (e ,, ,e 2,) , t=1,2,......n. The quality of a forecast is to be judged on
some specified function g(e) of the forecast error, e. Then, the null hypothesis equality of expected forecast performance is
of
Els@u)-s(er,)l=o
Define d , = g(e u)
- g(e r,)
7 =n-'la
t=1
the variance
of
d is, asymptotically,
v
G) * n-t ll
,*zfr
k=l
where
of d , . This autocovariance
can be estimated
by
f r=n-'\{a,-a)@,-o-d)
t=k+l
s,
= [ tr
@)]'''
.a
Under the null hypothesis, this statistic has an asymptotic normal diskibution. Diebold and Mariano considered mean squared eror as the standard of forecast
quality, that is,
g(e) = e' .
68
V.
competing
forecasts. The idea of forecast encompassing was formalized and extended by Chong
and Hendry (1986). Suppose we have two forecasts,
f'
,*0,, artd
t'
regression Y ,*k = F o+ F
,t'
,*0,,+
,t'
,*k,,*t
,*k,,
If (B * F, F,
if
(P
other (B
Fair and Shiller (1989, 1990) take a different but related approach
based on methodology. Their test is popularly known as the Information Content
Test. They argued that many econometric models are used to forecast economic activity which differ in structure and in the data used. So their forecasts are not
perfectly correlated with each other. This necessitates the developing of some test which enables to find out whether each model have a strength of its own, so that each
forecast represents useful information unique to it, or does one model dominate in the sense
They
(Y,*o-Y,) If
neither model
= d+
P(Yt,*k,,-Y,)+y(Y' t+r,z-Y,)*,*r.,
If
both
69
and
If
further relevant information as well, then B but not 7 should be non-zero. So one
estimates the above equation for different model's forecasts and test the hypothesis
lf ,
k period
ahead not
in
the
2,
and
Fair and Shiller's test bears some relation to encompassing tests but is not exactly identical to it. For instance, Fair and Shiller does not constrain
B arf y to
sum to one, as usually the case for encompassing tests. However, it is not difficult to
perform the forecast encompassing test in the Fair-Shiller framework. We can test the
forecast
encompassing, the Chong-Hendry and Fair-Shiller regressions are identical. When the
of of
model. Henriksson and Merton (1981) developed a test which is essentially a test
70
the directional forecasting accuracy of a model. The directional accuracy has been
shown to be highly correlated with actual trading profits.
Forecasts
Actuals
<0
>0
P ,, (O ,,)
P ,, P
(O ri)
P,.(O,)
<0
P ,, (O .i,)
,, (O ii)
I-p t (O i)
1(o)
>0
P,(o.,)
l-p r.(o i)
Where p ,i is the joint probability that an observation will belong to the ith row and
jth column, p.i end pi. tre the marginal probabilities, with . denoting
summation
Pr=b
and
P.t
The null hypothesis that a direction-of-change forecast has no value is that the
forecasts and actuals are independent, in which case
pi
brief discussion on directional analysis of forecasts refer Ash, Smyth and Heravi
(1ee8)).
The formal H-M test relies on a theorem in Merton (1981) that shows,
7t
conditional probabilities
of a correct
forecasts,
pttpz,
implies that the forecast has no value when actual and forecasts of a series are distributed independently and
pttpz=\.
Henriksson and Merton tests whether actual and predicted series are independent.
i, , =! o ^a
E
b -o ''. Then o
r=p
i.
one consistently estimates the expected cell counts under the null,
.i
,bY
o,o, ^t,o+. =
,,
E,j
- Z' ,.
72
Chupter V
We use monthly data in the present study. The time period covered in our study is from January 1993 to JuJy 1999. The exchange rate used in this study is Indian Rupee-US Dollar bilateral spot exchange rate defined as the number of Rupees
per unit of Dollar. Money supply is measured by
Ml
is proxied by the General Index of Industrial Production (IIP). For India, IIP figures for the period January 1993 to March 1998 are given for the base year 1980-81:100,
while for the period April 1998 to July 1999, IIP figures correspond to the base year
1993-94:100. The two series are spliced to obtain the whole series at 1980-81 prices.
For US, the IIP figures correspond to the base year 1992:100.Interest rate figures for both countries coffespond to 3-month Treasury Bill rates. Prices used in this study are Consumer Price Index
the
Industrial Workers (base : 1982:100); while those for US corresponds to the CPI for
mentioned data
for India
are
of
1999 ; while for US they are obtained from the Federal Reserve Bank, Minneopolis
obtained from the Monthly Abstracts of Statistics, Government of India, and given in terms of rupees. Monthly output, prices, money supply and trade balance data are
seasonally adjusted.
73
Chapter VI
Empirical Results
KPSS and Bayesian unit root test. Results of the unit root tests are reported in
Section A. A11 the variables under the present study tums out to be an integrated
process of order 1. Given that the series are I(1)
Engle-
Granger (EG) and Johansen-Juselius (JJ) tests of cointegration to estimate the long-
run equilibrium relationships. Section B describes the cointegration test results and
the existence of the monetary model as a long-run equilibrium relationship. We also
test for the presence any particular version of the monetary model in the Indian
economy. This section also reports the estimation result of the vector error correction
model for the purpose of generating forecasts of the exchange rate. Section C
describes the estimation results
Bayesian vector
autoregression based on the Minnesota prior and thereafter, forecasts are generated
forecasting
exercise has been carried out whereby forecasts are generated for one to twelve month forecast horizon. Finally, we run abattery of forecast evaluation tests to assess
the quality of the forecasts, reported in Section E.
74
bill
are given
January 1993 to
December 1996.
till
the last
sample point, viz. July 1999, is reached. Unit root tests have been carried out by this
rolling regression technique. This will enable us to find out whether the stochastic
trend is present in the variables under consideration for whole of the forecasting period, that
is,
from January 1997 to July 1999. Unit root tests have been performed
on both the individual variables, that is on the spot exchange rate, IIP of both
countries, money supply (M1) of both countries, and on the three-month treasury
bill
rates, as well as on the relative value of the variables, that is, on the relative money supply, relative interest rate and relative IIP.
We first carry out the traditional Dickey-Fuller (DF) and PhillipsPerron (PP) test to find out the presence of stochastic trend in the series. Logarithm of the bilateral spot exchange rate is a natural candidate to begin the analysis as this
is the central variable of the present study. Tablesl.l (A) and (B) gives the DF and
PP test results for the levels of the variables. We have presented here the
full
sample
result for all the variables, that is, covering the period January 1993 to July 1997.
The conclusion remains unchanged for any of the sub-periods starting from the
period I 993
:01
-1996:12.
DF test requires a sequential testing procedure, starting from a general model which allows for a deterministic trend in the data to a simple model which
75
tests for the presence of a pure random walk. In the general model the statistic that
by e ,. The
statistic is -2.3064 whereas the critical value is -3.41 (at 5% significance level). Since
/ presence of a
deterministic trend affects the stochastic trend inference. So it is natural to test for a
presence
absence
of a deterministic
the
, statistic and
rstatistic is3.2314 which is less than the critical value of 6.25 (5% significance
level) implying the presence of a stochastic trend but no deterministic trend. We then move to the next model - one with a constant and no trend. Here the null of unit root is evaluated by the
gets
accepted at 5oh significance level. We use this regression to carry out another F-test
to find out whether the DGP (Data Generating Process) is a random walk with drift.
We
therefore proceeded to find out whether the data generating process (DGP) is a pure random walk. This has been caried out by estimating the simplest specification - one
with no constant and no trend. Here the relevant.statistic is q . The calculated value
of this statistic is 2.2078. Given this is a left-tail test, the null hypothesis of unit root
does not get rejected atany
Given the low power of the DF test which has the implication that it
tends to accept the null hypothesis of unit root 'too' often one needs to substantiate
76
the result of the DF tests with some other tests. Phillips-Perron (PP) test is a natural candidate since it also has the same null of the presence of a unit root and has a better
power than the DF test. Result of the PP test for the levels is given in Table 1.1(B).
Z(td,
)and
Z(ta- , )
to
those
of
,and
of
the
Z (t d , ) statistic is -2.2456 which is less than the critical value at lYo, 5o/o, and l}Yo
conclusion is
a. , )
it is I(1).
50
and, l0o/o
significance level.
Given the sequential nature of the DF test, we stop where the null of unit root gets rejected. The results of the PP test, given
results. So, from the DF and PP tests we can finally concluded that the spot exchange rate is integrated of order 1, i.e., it is I(1).
We now look into the time series properties of other variables which may help to explain the movements of the exchange rate - output (proxied by the
index of industrial production (IIP)), money supply (as measured by
rates (measured by the three-month treasury
Ml)
and interest
bill
motivated by the monetary model. The results of the Dickey-Fuller and PhillipsPerron tests are given in Table 1. We refrain from giving a detailed description of the
test procedure here. However, the table below gives the final conclusion from these
tests.
Summary of the Dickey-Fuller and Phillips-Perron test Time Span : January 1993 - July 1999
Exchange Rate
Y Y Y N
Y
Y Y Y
Y Y
eratlon
IS,
Bill Rate
Y
presence o Unit root in the series under
Y
is I(1).
unanimous conclusion by both the tests that the series under consideration are I(1).
Only in Indian
Ml
different tests. So we may need to look into some other unit root tests to come into
any clear cut conclusion regarding this variable. In fact, latter on we perform both the KPSS and Bayesian unit root tests to cross-check our conclusion from the DF and PP
tests.
relative interest rates - as these variables will be later used to explain the exchange
18
in Table 2.
for
the
logarithm of the relative index of industrial production. Dickey-Fuller test results for
the levels are given in Table 2.I(A). The calculated values of the C E ,e
, and E
statistics are -1.6628, -2.117 and 0.1319 respectively. All of these falls in the nonrejection region at
Table 2.1(B) also supports the conclusion of the DF test. So a stochastic kend is
present in the relative IIP. To find out whether the series is integrated of higher order,
we undertake DF and PP test on the first differences of the relative IIP. Results are
reported in Table 2.2 (A) and (B). The DF test on first differences fails to reject the
null of unit root at l%o and 5%o significance level. However, the PP test strongly
reject the null of unit root in the relative IIP series. So we can conclude that the
relative IIP series is I(1).
We now look at the logarithm of the relative money supply as given by
M1. DF tests reported in Table 2.1(A) indicate that the series is nonstationary in
level. The calculated values of the e , ,C
and
The PP test on the levels (Table 2.1(B)) strongly supports the null of unit root at any
of the three significance level under consideration here. The DF and PP tests on first
difference of the series strongly rejects the null of unit root. In fact, the calculated
value of the
f,
statistic is -5.0838 (Table 2.2 (A)) which leads to the rejection of the
null of unit root in the first step only. Thus, we can conclude that the logarithm of the
relative money supply is I(1).
79
g statistics are
2.007, -2.1418 and -1.770 respectively. This clearly indicates the presence of unit
5o/o
results on the levels strongly supports the DF conclusion. The calculated value Z (t d , ) and Z (t
of
a. , )
falls in the acceptance region. Thus both the tests clearly points out towards the
presence of a stochastic trend in the level of the series. To infer on the degree
of
integration we carry out the DF and PP tests on the first differences of the series. Results are given
in Table 2.2 (B). Both DF and PP test concludes that the first
difference ofthe relative interest rate is stationary. So the relative interest rate series
is
I(t).
Summary of the Dickey-Fuller and Phillips-Perron test Time Span : January 1993 - July 1999
Y Y Y
Y Y
Y
on
Ml
ls
It is a well established fact that standard unit root tests fail to reject the null hypothesis of a unit root for many economic time series. In these standard unit
root tests (DF and PP) the unit root is the null hypothesis to be tested. An explanation
for the common failure to reject a unit root is simply that most economic time series
are not very informative about whether or not there is a unit root.
80
DeJong et. al. (1991) provide evidence that the DF tests have low power against
stable autoregressive alternatives with roots near unity, and Diebold and Rudebusch
(1990) show that they also have low power against fractionally integrated
alternatives. Kwiakowshi et. al. (1992) developed a unit root test, popularly know as
theIKP,SS test, which tests the null hypothesis of stationarity against the alternative
of
a unit root. We intend to apply this test to crosscheck our inferences from the
standard DF and PP tests.
- ry r,
stationarity is tested, and rl , , where the null of trend stationarity is tested, against the alternative of a unit root. In the calculation of the KPSS test statistic, the choice
of lag
truncation parameter
monotonically
in l,
recommended calculation
of
,S2
of /
variance estimate and hence the KPSS test statistic have " settled " down. However,
setting
too high can result in significant loss of power. Keeping this trade-off in
to be equal to five.
Table 3 and 4 reports the KPSS test for the levels of the variables
under this study. At the outset
the interest rates are in logarithm. Table 3.1. presents the result of the KpSS test
when the null hypothesis is that the series is level stationary. For the exchange rate
series, the null of level stationarity is getting rejected even at 1% significance level at
all values
of / as the calculated value of the test statistic is greater than the critical
value. Table 3.2 gives the KPSS test result where the null hypothesis is trend
81
stationarity. In the case of exchange rate, the calculated value the critical value at lo/o significance level at
of
rl , statistic exceeds
conclusion of the DF and PP tests that the bilateral India-US spot exchange rate
indeed contain a unit root.
KPSS test has been applied individually to the levels of all the series
under the present study. As far as the null of level stationary is considered, except for
Ml,
all I
The US TB rate is getting rejected at 5% significance level atl>3, while that for US
Ml
all /. In case of
less
than the critical value (at any of the 1, 5 and 10% significance level), implying that the null of level stationary is not getting rejected. However, given that the power
of
as /
of level
of null of trend stationary, the calculated value of the ry exceeds the critical value at
"
10% significance level at all 1, except for the US IIP. For US IIP,
at l>3
the
null of
trend stationary is not getting rejected even at 10% significance level. Invoking the
same argument as in the case of the Indian treasury
bill
that US IIP is indeed trend stationary. Thus, KPSS test on the level of the variables under the present study reinforces the DF and PP tests result that all the series indeed
contain a unit root. Table below summarizes the result of the KPSS test.
82
(Level)
Exchange Rate
N N
N N N N
N N N N
N N
Ml
Ml
stands
In other words, it
implies that unit root is present in the relevant series. We also test for the level and trend stationarity for the relative value the variables - relative money supply, relative IIP and relative treasury bill rate.
of
A11
the variables, except the relative interest rate, are given in logarithm term. The results
of the KPSS test are given in Tables 4.1 and 4.2.Table 4.1 give the results for the
KPSS test when the null hypothesis of level stationary. For
all
the
null hypothesis
statistic statistic
the ? ,
for testing the null hypothesis of trend stationary. For relative IIP and relative money supply series, the calculated value of the test statistic exceeds the critical value at lo/o significance level for
value
83
of the
r7
all / except at
1999
rr
respectlve nu
As
not
very
informative about whether or not there is a unit root, which attributes towards the
poor performance of the standard unit root tests. Bayesian unit root analysis offers an
alternative means of evaluating how informative the data are regarding the presence
and
p=1, where p
is
84
the autoregressive parameter. A lower limit for the stationary part of the prior is also specified such that prior for
we take a
0.8 since for this level the odds between stationarity and the presence of a
are
unit root are approximately even. The results of the Bayesian unit root test
reported in Table 5. As usual, all the variables except the interest rates are taken in
logarithm term.
Table 5.1 reports the Bayesian unit root result for the level of the
exchange rate series is presented. Here the squared t (0.046) is less than the Schwarz
limit (8.195) thereby strongly supporting the presence of a unit root in the the
exchange rate series.
value for alpha at which the posterior odds for and against unit roots are even. A
higher value of ' marginal alpha ' favours the presence of unit root. A high ' marginal
alpha ' of 0.9215 supports the presence of unit root in the exchange rate series. For all the series reported in the Table 5.1. the squared t is less than Schwartzlimit indicating
the presence of a unit root in the level of these series. However,
Indian
Ml
Ml.
Also,
very less than the latter value. So one need to cautiously interpret the result of unit
root for these two series and need to be substantiated with other unit root tests.
Table 5.2. reports the Bayesian unit root test for the relative variables -
relative
squared
IIIP,
relative money supply and relative interest rate. For all the series the
t is less than the Schwarz limit indicating the presence of unit root in all
these series. However, the ' marginal alpha' for all the three variables are not very
high. So it would be appropriate to substantiate the Bayesian test with other unit root
test to conclude about the nature of these time series.
85
Summary of the Unit Root Tests Time Span : January 1993 - July 1999
(Levet)
Exchange Rate
Y Y
Y N Y
Y Y
Y Y Y
Y Y
Y
Y Y Y Y Y Y Y
Y Y Y
Y
Ml
Y Y Y
Y Y Y Y
ton.
Bill
Rate
Y Y Y Y Y
US M1 Relative IIP Relative Treasury Bill Rate Relative Money Supply "
Y Y Y
Section B : Cointegration, Long-ran Equilibrium Relationship and Vector Ewor Coruection Model
(i) Cointegration:
From the above discussion on unit root tests we can conclude that all
the series under consideration are non-stationary. Granger and Newbold (1974)
pointed out the possibility of spurious regression in the event of running an OLS
86
are "
co*integrated
concept of cointegration based on the time series properties of the variables where
they talked about the possibility of a linear combination the I(1) variables which is
msans that
Table 6 for the full sample period January 1993 to July 1999. We work with the
relative value of the variables - relative IIP, relative three-month treasury bill rates, relative money supply as given by
Ml,
relative three-month treasury bill rate are in logarithm. Our choice of the variables is
II). To
postulates existence
supply, interest rate,output, prices and expected inflation, depending on the variant
of
the monetary model we are estimating. We first test for the Flexible-price and
Dombusch's sticky price version
of the monetary
equilibrium relationship between the exchange rate, money supply, interest rate and
output.
is -3.3001 which is greater than critical value of -3.81 (10% significance level) and
87
hence lies on the non-rejection zone. This implies that the residuals from the
regression are non-stationary and hence the variables are not co-integrated. Even when we allow for a trend in the regression equation the residuals are turning out to
be non-stationary. The PP statistics also reinforces the DF results.
It is well
has several problems. First, it is very sensitive to the normalisation in the sense that
as dependent variable ,
it
null of no-cointegration
it
among the variables, which may be justifred by the economic theory. Johansen (1988) and Johansen and Juselius (JJ) (1990) developed a
cointegration test among the variables which takes into account the drawbacks of the
EG test. It uses the maximum likelihood estimates to find out the number of cointegrating vectors among the variables. JJ test treats all the variables symmetrically
and thus
it
all I(1) variables are assumed to be endogenous. Optimal lag length selection is an
important problem for the estimation
will
preserve
of
in the system,
whereas a longer lag length would exhaust the degrees of freedom very quickly but remove the serial correlation problem.
no serial correlation problem in the individual equation of the system since presence
of
to
88
it
Cheung and
that serial correlation is a serious problem for the Johansen approach and that the
usual lag length selection criteria (Akaike Information Criterion and Schwarz
Bayesian Criterion) may be inadequate, particularly in the presence of moving arerage
errors. In the present study we employ four tests to select the optimal lag length
of
of 1. The LR
a lag length
test, which under null hypothesis, follows a chi-square test, also gives us
of 1. We therefore re-estimated the VAR system with one lag of all the
variables and tested for the presence of serial correlation in the system. We found
serial correlation problem in the system. This leads us to move to a higher lag length
at which there are no serial correlation problem. We choose a lag
length of three.
It is worth to point out that we are working with the relative value of
the variables. One prime reason for restricting the coefficients to be equal for both countries is to preserve degrees of freedom given relatively small post-liberalisation period in India. Ideally we would like to allow the coefficients to be unequal for both
countries. Whether this affects the forecasting performance is not very clear from the
literature, for instance, Meese and Rogoff (1983) found that even after allowing the coefficients to vary across the countries there was no significant improvement in the
forecasting performance of the monetary models.
will
of
89
likelihood ratio test and follows a chi-square distribution under the null hypothesis. The results of the block exogeneity test is given in Table indicate that null hypothesis
8.
of the exchange rate is not present in any of the equation of the system, the LR test
statistic value is given by 25.3496 with a p-value of 0.003 indicating that we can reject the null hypothesis even at 1% significance level. Similar results hold for other variables indicating that none of the variables under consideration can be excluded from our system of VAR.
of
I ^u*
and )" oo, statistics - used in the JJ test. 2 *u* has got a much
sharper alternative than )" ,,," since the later tests the null hypothesis that the number
of
to pin down the number of cointegrating vectors. The results of the cointegration test
is given in Table 9. Trace statistic rejects the null of no-cointegration at 5oh and
significance leve.
lo/o
the calculated values of the statistic exceeds the critical values at 5Yo and ljoh
significance level.
90
oo" statistrcs
gives us one cointegrating vector, the ), -u* statistic indicates the presence of two cointegrating vectors.
vectors between the exchangerate, money supplies, ou@uts and interest rates.
by the three month treasury bill rate, and m is the money supply as measured by the M1. (* indicates a corresponding variable for the foreign country, here it is USA). All
the variables are in logarithm, except the interest-rate. The figures given in the
brackets are the calculated value of the likelihood ratio of testing the null
of
the
91
the null of no significant presence, the statistic follows a chi-square distribution with one degree of freedom. Given that the critical value of chi-square with one degree
of
freedom is 5.84 at l0o/o significance level and 3.24 at 5o/o significance level, we can conclude that the variables are significantly present in the cointegrating vector. The long-run relationship confirms to the flexible-price version of the
is
that as domestic income goes up relative to the foreign income, there is an excess
prices
models). This then ensures the negative relationship between the exchange rate and
the output. Moving on to the interest differential term, our results confirm to the
theoretical signs of the flexible-price monetary model. Here, the exchange rate is positively related to interest differential. As domestic interest goes up relative to the
foreign interest rate, which basically reflects higher domestic expected inflation,
people hold less domestic money, thereby creating an excess supply in the domestic
money market. To clear the money market, prices increase and as Purchasing Power
exchange rate are positively related, again confirming to the theoretical conclusions
the flexible-price version of the monetary models. An increase in the domestic money
supply vis-a-vis the foreign money supply creates an excess supply in the domestic money market. Domestic prices increase to clear the money market which, via the
purchasing power parity condition, leads to a depreciation of the domestic currency.
92
LOne
models, that is
frequently tested is the long-run proportionality betrveen money supply and exchange
rate. We have tested this restriction in our cointegrating framework. This test imposes a value of one to the money supply coefficient and carry out a likelihood ratio test.
Under the null hypothesis of the restriction being valid, the test statistic follows a chisquare statistic with one degrees of freedom. The calculated value of the statistic is
5o/o and
l0%
MacDonld and Taylor (1993, 1994) and Choudhry and Lawler (1997), the rejection
of
this proportionality restriction does not invalidate the monetary model as a long-run equilibrium condition given that signs of the cointegrating vector corresponds to those
postulated by the monetary model. We, therefore, conclude that the flexible-price monetary model is a valid framework Indian Economy.)
for
confirm
exchange rute
(0.046)
(0.767)
(0.2s4)
(0.23e)
First parenthesis gives us the likelihood ratio value of testing the null
hypothesis
relationships. The second parenthesis contains the corresponding p-values. Only the
constant term was turning out to be significant at the SYosignificance level.
All
other
93
variables are not only incorrectly signed but also statistically not significant
as
indicated by a very high p-value. Plots of the two cointegrating vectors clearly bring
0.4 0.2 0
\.aA r,
r^ ,-
/\nn.A-^ A rrv
o tu
-0.2 -0.4
vv
^
-0.6 -0.8
-1
\A^
\^^\YEAR
.J\
w
J"
ECMl is the plot of the error correction term which confirm to the Monetary model
ECM2 is the plot of the error correction term which does not confirm to the Monetary model
(iii)
Vector
We use the economically meaningful cointegrating vector to develop a vector effor colrection model (VECM) to generate out-of-sample forecasts. Engle and
Yoo (1987) pointed out that forecasts taken from cointegrated systems are 'tied
together'because the cointegrating relations must 'hold exactly in the long-run'. They demonstrate in a series of Monte Carlo experiments that incorporating cointegration
into the forecasting model, can reduce mearl squared forecast erors by up
to
40%o
at
94
medium to long forecasts. Lin and Tsay (1996) found that for simulated data imposing
Result of the
full sample
estimation
model (VECM)
encouraging, except for the error-correction term which is negative (-0.08032) and
significant (t-statistic is -3.1284). This shows that the any deviations from the longrun relationship gets corrected by 8 percentage points each period. The individual t-statistics of other regressors are mostly not significant, except the first lag of the
relative interest term. But this is not totally unexpected because of the possible
presence of the multicollinearity problem among the lagged regressors. But what is
really important for the effor-corection model is that the error correction term should
be negatively signed and statistically significant, thereby justifying the estimation
of
"""iV" use the most commonly used Minnesota prior which involves specification of
three "hyper-parameters"
parameter
w, symmetric weights
given to the lags of other variables in the equation; and d, decay parameter controlling
95
for the decreasing importance of the lags of the variables. Since the ultimate motive
of
developing a bayesian VAR is to generate forecasts which beats the random walk, we
choose that prior which minimises the average of the one to twelve-step mean squared
errors and Theil's U statistics for the out-of-sample forecasts. That is, we estimate the bayesian model initially with each prior over the period Jan. 1993 - Dec.1996, and
U statistics for
each
We choose that prior which gives us the minimum of the ayerage root mean square
erors and Theil's inequality. However, this is also not a very easy proposition
there could be an infinite number
as
empirical studies on the bayesian analysis to restrict the prior choice space among the combinations
spencer (1993), Todd (198a)). We use a harmonic decay function to tighten up the
The result of this analysis is given in Table 12. We start with the
parameters of the prior recommended by Doan (1990). The overall tightness, the harmonic lag decay, d, are set at 0.2 and 1 respectively.
I , and
A symmetric interaction
function -
f(ij) - is assumed with w:0.5. The average of the root mean square errors
(RMSEs) and Theil's U statistic is given by 0.05417 and 0.9097 respectively. We then
did a grid search for the optimal values of the prior. We kept the overall tightness prior equal to 0.2, but reduced the value of w to 0.4. It should be noted that reducing
the value of w, that is, decreasing the interaction, tightens the prior. We have marginal
96
the harmonic lag decay fixed at 1.0 and varying the values
), :
0.1 and w:0.4 produces the minimum of the average RMSE and Theil's U. We
then varied the harmonic lag decay, d, parameter to 2. So searching over all the
parameter values we conclude that the combination
of ),:0.1, w
optimal as this gives us the minimum average RMSEs and Theil's prior to generate the forecasts from the bayesian VAR.
U.
We use this
and
rate determination. Various proxies have been tried out in capturing the expected inflation differential between countries, most popular being the long-run government
bond rate differential and past twelve-month inflation differential. However, because
of the lack of time series data on long term government bond rate for India
inherent backward nature of the other proxies, we decided to
and
fit
an
ARIMA model to
the inflation series of both the countries and generate twelve-month ahead forecasts as the proxy for the expected inflation differential. For the cumulative trade balance, we
restricted ourselves
to the bilateral
if we take overall
Dickey-Fuller and Phillips-Perron test results for the inflation series for
both countries, generated from the consumer price index numbers (CPD, and the log of the cumulative bilateral trade balance (in logarithm term) are given in the Table 13. The results indicate that we can reject the null of no-unit root for both the series. So
97
we went on to
fit an ARMA
is from
1980:01 to 1993:01. Forecasted inflation series for both the countries turned out to be stationary.
We face a stumbling block due to the fact that both the expected
inflation differential and the bilateral cumulative trade balance series tumed out to be
stationary. This prevented us from testing the theory in the cointegration framework
in the sense that we cannot include them directly in the cointegration relationship and
check whether their signs confirm to the theory. But still to find out whether the
presence of these variables does play any role
use
these variables
framework. We employ the same prior as we did earlier in the bayesian estimation
of
the monetary model. We call this model Bayesian VAR with deterministic variable
(BVARD).
model. We argued that because of relatively small post-liberalisation period we refrain from allowing different coefficeints for the two countries. However, the
bayesian approach helps us to avoid the degrees of freedom problem. We therefore estimate a bayeseian version of the monetary model where we allow the coefficients
of the regressors to vary between the two countries. This we term as an o' LJnrestricted Bayesian Vector Autoregression (UBVAR)
".
One clarification
should be done at this stage. Our usage of the word ounrestricted' have got a special
98
meaning of allowing the coefficients of the regressors to vary across the countries in
of )":0.1, w - 0.4,
and
be the optimal prior based on the average of the RMSE and Theil's U statistics. We use this prior specification to generate the forecasts from the unrestricted bayesain vector autoregression (UBVAR).
relatively large information set for estimation and updating the forecasts from these
models may be
univariate models,
popularized by Box-Jenkins, which uses very little information set for estimation and forecasting and updating forecasts from these models are very easy compared to the
quite well
in
terms
of
to
the
multivariate forecasting models. First step in building an ARIMA model is to look at the autocorelation function (ACF) and partial autocorrelation (PACF) functions to have an idea about the nature of the data generating process. The plots of ACF and PACF are given in the
appendix. Plots of ACF and PACF on the levels of the log of the exchange rate shows
99
that ACF dies down very slowly while PACF has one spike dt lag 1 after which it dies
down very rapidly. Problem with this visual inspection is that this kind of ACF and PACF behaviour is generated by both an AR(l) process and a simple random walk
process. So
of
the series shows that both of them dies down very rapidly. This increases the
suspicision that the log
Infact, when we perform the formal tests of unit root on the spot of the exchange rate,
discussed at the beginning
of the exchange rate series. We give the estimation results for various specification
the ARIMA models spanning the time period 1993:01
of
ARIMA specification that passes through a battery of model adequacy measures absence
of parsimony. Apart from the above mentioned battery of tests one also needs to keep
in mind that the chosen model satisff the two important requirements of inevitability
and stationarity. Based on all these criterion, we choose the ARIMA (2,1)
specification. This model has been used to generate the forecasts of the exchange rate
and compared with the multivariate forecasts from the VAR models.
100
Monthly exchange rate forecasts were generated for the simple random
walk (RW), ARIMA, vector error corection model (VECM), bayesian vector
autoregression (BVAR), bayesian vector autoregression with deterministic variables
forecast horizons.
the logarithm value of the spot exchange rate and forecasts are also generated for the
logarithm value of the spot exchange rate. For compariosn for forecast performance we have also developed two multivariate models - a level VAR (LVAR), which is
justifiable given that the variables are cointegrated, and a bayesian vector error
correction model (BVECM), which
is
generating the out-of-sample forecasts. In this method we initially estimate all the models over the period 1993:01-1996:12 and forecasts are generated for the period
1997 01-1999:07. Next, we increase our estimation period
by adding one
sample
point and reestimate all the models for the period 1993:01-tr997:01and based on this
we generate our out-of-sample forecasts. This forecasting strategy gives us 31 onemonth ahead ,29 three-month ahead, 26 six-month ahead, 23 nine-month ahead, and
101
16.
Forecast error is calculated as the spot rate minus the forecast rate. Table reports two
- root
Theil's U statistic (U). It also reports three other statistics that also sometime appear in the forecasting literature - mean absolute error (MAE), root mean square percentage error (RMSPE) and mean absolute percentage error (MAPE).
We first look at the one-month ahead forecast performance of the alternative models.
One of the most challenging task that a forecaster faces is to generate forecasts that
beats the naiVe forecasts charucteized
the short forecast horizon. The most popular statistic to find out these is Theil's
inequality statistic. The model which beats the random walkforecast has a value of U
less
than.l. In case of one-month ahead forecasts, only BVECM model has U>1.
of
the RW forecast (0.01486). ARIMA occupies the second position with a RMSE value
model in the one-month horizon. For the other models, the picture is not that clear. For instance, in terms of RMSPE, LVAR, BVAR, BVARD, BVECM and UBVAR
102
BVECM and UBVAR outperforms the random walk, while all of them show a poor
performance in terms of MAE and MAPE. We, however, rely on the Theil's U and RMSE to conclude that most of the models beat the random walk forecasts at the one-
RW
ARIMA VECM
UBVAR
RMSE
THEIL'S U MAE
RMSPE
MAPE Noie : The numbers in the cells are the rankings of the various forecasting models
across various forecast evaluation measures at this forecast horizon. Three Month Forecast Horizon :
substantially compared to the one-month ahead forecasts. VECM, which was tuming
out to be the best model in terms of one-month ahead forecasting performance, posted
a very poor perfofinance in the three-month horizon. Indeed, it failed to beat the
random walk forecasts in terms of RMSE and also had a Theil's U value greater than
by beating
the
I t is worth to point out again that the term Unrestricted Bayesian VAR has been used in this paper to
indicate that the coefficients of the regressors in the exchange rate determination model are allowed to
r03
random walk model in terms of all the descriptive statistics. But it was the IIBVAR
which produced the best forecast in this horizon by posting the lowest RMSE
(0.029712) and Theil's U (0.90191) among the competing models. BVAR, BVARD
and LVAR also outperformed the RW model in terms of RMSE and Theil's U. For
other statistics, the situation is the same as the one-month ahead forecasts with the
in
terms
of
RMSPE, while
performing worse in terms of MAE and MAPE. Thus we can conclude that in the
three-month horizon,
RW
Statistics
ARIMA VECM
2 2
1
UBVAR
ffi
THEIL'S U MAE
RMSPE
)
5
8 8
J ^ J
7 7
8
4
5
2
5
7
8
4 4
5
I I
6
8
2
J
MAPE
Note : The numbers in the cells are the rankings of the various forecasting across various forecast evaluation measures at this forecast horizon.
Six
At the six-month
it is the UBVAR
model
which gave the best forecasting perfonnance in terms of the descriptive statistics. VECM, which posted a very poor perfofinance at the three-month horizon, bounced
back to register an impressive performance at the six-month horizon by beating the
statistics. ARIMA
continued with its impressive performance by occupying a close second position after
the UBVAR model. BVAR also outperformed the random walk forecasts at this
horizon. BVECM continued with its dismal performance at the six-month horizon while the LVAR forecasts were unable to beat the random walk forecasts. In terms of
RMSPE, all the models which have U<1, beats the random walk forecasts. Contrary
to earlier forecast horizon, ARIMA and UBVAR beats the random walk forecasts in
terms of MAE and MAPE criterion also. So we can conclude that at the six-month
forecast horizon AR[MA, UBVAR, BVAR, and BVARD outperformed the random
RW
6
ARIMA VECM
2 2
1
UBVAR
RMSE
5 5
8 8
8 8 8
4 4
5
THEIL'S U MAE
RMSPE
6
J
a
I
2 2
6
J
4
5
6
J
4
5
MAPE
vanous
asting models
105
At the nine-month
BVAR, BVARD and UBVAR models beats the random walk forecasts by the virtue
of having a Theil's U statistic value of less than one and RMSE less than the
corresponding figure for the random walk model. UBVAR model again outperformed
(0.785805).
VECM comes a close second with a RMSE value of 0.06615 and U:0.812410.
BVAR model occupies the third position followed by the ARIMA and BVARD.
LVAR and BVECM model performed very poorly and was unable to beat the random walk model as they have a Theil's U value of greater than one. In terms of RMSPE
and MAE the models with
U<l
in terms of
MAPE, ARIMA, VECM and UBVAR model beats the random walk forecast. So at
the nine-month ahead forecast horizon I-IBVAR model outperforms all other models in terms of all the statistics followed by the VECM.
UBVAR
m
MAE
Statistics
6 6 6 6
2 2 J
1
J
a
8 8 8 8 8
5 5
THEIL'S U
7 7
7 7
J
5 5 5
4 4
6
RMSPE
2
J
MAPE
Note : The numbers in the cells are the rankings of the various forecasting models
across various forecast evaluation measures at this forecast horizon.
106
At the twelve-month
remains unchanged compared
of the models
to the nine-month
outperformed all other models including the random walk model, followed by the
A11
RV/
7
7 7
ARIMA VECM
5
5
TIBVAR
RMSE
8 8 8
8
2 2
5
THEIL'S U MAE
RMSPE
4
J
5
2
a J
a
6
5
4 4
2 2
MAPE
considered.
better than the univariate benchmark model across the forecasting horizon.
However, no one multivariate model consistently out-predicts the forecasts from the ARIMA model. At one month forecast horizon
six month
it is UBVAR,
107
while in the twelve month they are VECM, IIBVAR, BVAR and BVARD.
these rankings are based on RMSE and Theil's U statistic.
A11
The performance of the ARIMA model deteriorates over the longer forecast horizon. This is expected as ARIMA model is specifically used to generate
forecasts over the short and medium forecast horizon. Infact,
it
consistently
occupies the second position at one, three, and six month ahead forecast horizon.
twelve month forecast horizon, it is the VECM which outperforms all the bayesian
models. However,
at other
UBVAR, outperforms the VECM. Again, this conclusion is based on the RMSE
and Theil's U statistics.
Among the bayesian models, it is the UBVAR which is turning out to be the best performer across the forecast horizon followed by the BVAR.
Forecast performance of all the models deteriorate as we move to the future which
is
evident from the increasing RMSE, RMSPE, MAE and MAPE. This confirms
as
models. So we drop these two models from our further analysis. We concentrate on the following 5 models
in our
108
getting accepted at 10 ,
5o/o and
getting overwhelmingly accepted. Thus, we can conclude that at three-month forecast horizon forecasts from all the competing models are both unbiased and efficient.
the ARIMA model, none of the model produces unbiased forecasts. Even for the
unbiasedness
1o/o
significance
level. Moving on to the efficiency test, the results are agun turning out to be negative.
None of the forecasts are tuming out to be efficient.
Actual and Predicted series are cointegrated, at one, three and nine month forecast horizon. While they are cointegrated by both the Engle-Granger and JohansenJuselius methodology at one and nine month ahead forecast horizons, they are
cointegrated only by the Johansen-Juselius method at six month forecast horizon.
At one month ahead forecast horizon, none of the forecasts are unbiased. Only
ARIMA
horizon.
and
111
t*h:d+BP,*o*,*r,
where A ,*o is the actual series, P ,*o is the predicted series and h is the forecast
horizon.
The null of unbiasedness is given by the joint hypothesis
of
a,=0, and
=l
f=l
Given the existence of cointegration between the actual and predicted
series,
as
vector. The restrictions on the co-integrating vector could be thought following restrictions : (1
of
-1)
as the
as the
-1 0) as the unbiasedness
restrictions and (1
efficiency restrictions, where the elements in the bracket corresponds to the actual
series, predicted series and a constant respectively. Results are given
in Table 19.
Table 19.1 reports the result for the one-month ahead forecast horizon. As far as the
bias test is considered, none of the model's forecasts are turning out to be unbiased as
the calculated value of the chi-square statistic exceeds the critical value at the
conventional significance levels.
In
case
the
VECM's forecasts are turning out to be efficient as the null hypothesis cannot be
rejected at lo/o,5o/o and 10% significance level for
AzuMA and VECM qualiff among the competing models as far as the efficiency
criterion is considered. All other models fails to pass both the tests.
110
It is important to consider
the predicted series with the advent of the unit root and cointegration literature
(Cheung and Chinn, 1998
requirements
of the prime
integrated of the same order, and (2) they should be co-integrated. Otherwise the forecast effors
will
tests, across the forecast horizon, are reported in Table 17. We employ the traditional
of integration of
the actual and predicted series. The results indicate that the actual and predicted series
the
first
of
consistent forecast, viz., the actual and the predicted series are
and
the actual and predicted series. The summary results are given in Tables 18. Results indicate that the actual and the predicted series are co-integrated by both EG and JJ methodology at one- and nine-month forecast horizon, while it is co-integrated by the
six- and twelve-month forecast horizon. For all the cases where co-integaratiotn
exists, there is only one co-integrating vector.
are
IV). To
109
unbiased or efficient.
3l
forecasted values
is
good justification for carrying out non-parametric tests of unbiasedness which has better small sample properties. We employ two non-parametric tests
- sign-test and
wilcoxon rank-sum test. While the former tests for median unbiasedness rather than
mean unbiasedness, the later one, under the assumption of symmetric distribution
of
forecast elrors, tests for mean unbiasedness. The results of these tests are reported in
Table 20. Sign-test is a two tail test where we reject the null hypothesis
if S <r or if
S>n-f,
case
where n is the number sf *'ve and -'ve errors and t is the critical value. In
of
of
median
if
to 9.993 or
if S is greater
.In
case
conclude that ARIMA forecasts are unbiased based on the sign test.
tt2
also implies mean unbiasedness. We reject the null of mean significance level
(:
median)
0 at the
a if
orz.
if it is less than W
148, otherwise we
ARIMA
which does not fall in the critical region. Thus we can conclude from the Wilcoxon rank-sum test that the ARIMA forecasts are mean unbiased. So both the nonparametic test of biasedness gives us the same result that ARIMA forecasts are
unbiased at one-month ahead forecasts. This is in contrary to the parametric test
unbiasedness where the
of
nullof
fact that these tests have good finite-sample power and are insensitive to deviations
from the standard assumptions of normality and homoscedasticity that are very
critical for carrying out the parametric tests, we conclude that the ARIMA forecasts
are indeed unbiased.
and
Wilcoxon rank-sum tests, for the forecasts generated from the VECM, BVAR,
BVARD and UBVAR. The results are reported in the Table 20. The result clearly
indicates that for none of these models the forecasts were biased at the one-month forecast horizon, except the VECM forecasts.
In
case
the
VECM, the null of unbiasedness is getting rejected by the Wilcoxon rank-sum test.
However, the sign test accepts the null of median unbiasedness. So, in general, the nonparametric test overturns the conclusions of the parametric tests of unbiasedness
discussed earlier where none
refrain from performing the non-parametric bias test as either the test procedure could
ll3
andLopez (1996)).
for all the models at one month ahead forecast horizon. At three month forecasts
horizon all the models produce unbiased forecasts. Again, at the nine month
ahead horizon, none of the model's forecasts are tuming out to be unbiased.
of
forecasts from
the
VECM, while the sign test does not reject the null of unbiasedness, the Wilcoxonrank sum test does reject the null. Given that the Wilcoxon-rank sum test assumes that forecasts errors are symmetrically distributed, one may fall back on the sign
test to conclude that forecasts are unbiased.
form ARIMA and VECM are efficient. None of the other model's forecasts are efficient. In case of three month ahead forecast, all the forecasts are turning out
to be efficient. However, at the nine month ahead forecast horizon, the results are
again tuming out to be negative.
(tii) Equality of Forecast Eruors Test : Diebold and Mariano (1995) pointed out that mere looking at the
various forecast accuracy statistics and concluding that one model is outperforming
the other is not correct. We employ a test developed by them which tests for the null
hl.pothesis of no difference in the accuracy of the two competing models. We use the
tt4
loss-function of the form g (e) = e' , which allows one to test whether there is any
significant difference between the root-mean-square effors of the competing models. This is important because
it
some model may be outperforming the random walk model but there may not be any
Table2l.
Let us first consider the one-month ahead forecasts. The calculated value of the DMS for the pair of simple random walk (SRW) model and the ARIMA model is 1.2535,
which is insignificarrt at 10% significance level. (This test statistic, under the null
hypothesis, asymptotically follows a standard normal distribution, and
it is a two-tail
test). This implies that there is no significant difference between the forecast error
of
the SRW and ARIMA models. The DMS between the SRW and VECM is -3.7199
from the Diebold-Mariano test that the RMSE of the VECM is significantly lower
than that of the SRW model at one-month ahead forecast horizon. However, for other
models
significant implying that the forecast effors of these models are not significantly
different from that of the SRW model.
forecast
erors of none of the competing model is significantly different from that of the
115
simple random walk forecast. At the six-month ahead forecast horizon, agun, none
of
the model's forecast error is different from that of the simple random walk model. At
the nine-month ahead forecast hoizon, only the ARIMA model's forecast errors is
statistically different from that of the simple random walk model. Given that it has a
lower RMSE (infact, lowest among the competing models) we can conclude that
ARIMA model is significantly out-performing the simple random walk model. At the
twelve-month ahead forecast horizon,
statistically significant different RMSE from the simple random walk model.
significantly different from the SRV/ model. Forecast effors are also significantly different (as a pairwise) between the ARIMA and VECM, VECM and BVAR,
VECM and BVAR, and between VECM and UBVAR. Difference of forecast
effors also imply that there is statistically significant difference between the root
mean square elTors from these models.
At
to provide evidence of
At six month
statistically different from that of the random walk model. Only cases where
forecast effors were significantly different from each other are those of BVAR and
and
LIBVAR.
At the nine month ahead forecast horizon, it is only the ARIMA model which
produces forecast erors that are significantly different from that of the SRW.
ll6
ahead forecast
hoizon,
again, none
Fair and Shiller (1989, 1990) noted that the superiority of a particular
model in terms of forecast accuracy does not necessarily imply that the forecasts from
other models contain no additional information. Moreover, when the RMSEs are close
for two forecasts (this is particularly true in our study), little can be concluded about the relative merits of the two. This led Fair and Shiller develop an Information Content Test to find out whether one set of forecasts has more 'information' than the
competing models. This
competing model has more information relative to the simple random walk model.
The results of the information content test is given inTable22.
At the
VECM
have more information than the simple random walk forecasts. Considering the
as a pair,
contained
ARIMA model. Other pairs with the ARIMA model do not have coefficients
significant implying that none of the model contains any information useful for the
one-month ahead forecast of the spot exchangerate. Considering other combinations
tt7
find that in all these cases the coefficient of the VECM term not only to be positively signed but also statistically significant
coefficient
to
be
statistically insignificant. For the BVARD and UBVAR pair, the coefficient of the
BVARD term was significant but negatively signed which " is a perverse result in
economic terms as this implies that the information
is
negatively correlated with the actual exchange rate changes " (Liu, Gerlow and
Irwin (1994)).
Beyond one-month ahead, the results of the information content test is not very encouraging. At all other forecast horizon, viz. tltree to twelve months, either
the coefficients are statistically insignificant or they are significant but negatively
signed implying a perverse relation in economic terms. This implies that none of the
models at more than one-month ahead forecast horizon contains information which is
useful
to forecasting the spot exchange rate beyond that provided by the simple
random walk model. It should be noted that forecast errors are autocorrelated of order
MA(k-l), where k is the forecast horizon, for which we have used the Newy-West
heteroscedastic-autocorrelation consistent estimator
content test beyond one month horizon.
information
VECM forecasts.
ll8
encouraging. None of the model contained any 'information' beyond that of the simple random walk model.
to whether
'
naive
'
Modest (1987) developed a test based on Merton's (1981) work for evaluating the
direction-of-change forecasts. They tested the null hypothesis that a direction-ofchange forecast has no value by testing the null of independence between the actual changes and forecasted changes. The test statistic follows a chi-square distribution, under the null of independence, with one degree of freedom. Results are reported in Table 23. At one-month forecast horizon, none
of the models predicted changes in the spot exchange rate accurately. This is because
none of the calculated value of the chi-square statistic are statistically significant. The
picture improves somewhat at the three month ahead forecast horizon. Here forecasts from the VECM and UBVAR models predicted changes in the exchange rate that has
some value to the consumers as both of them has calculated chi-square statistic which
if
At the six-month
which
predicted changes in the exchange rate that has got some value in the sense that the
119
of the
forecasts results are again not positive since all of the models produces forecasts that
in
the
depreciation and appreciation of the spot exchange rate that is not statistically
correlated with the actual changes.
has some 'value' in the sense that the predicted changes in the exchange rate is not
and
as
medium period forecasts, viz. one, three and six month ahead forecasts,
indicated by RMSE and U ; however, its performance deteriorates in the long-run forecast horizon of nine and twelve months.
120
The multivaiate models able to outperform the ARIMA model across the forecast
horizon. At one month horizon, it is the vector effor correction model (VECM), at three and six month horizon
it is the Unrestricted
nine month horizon they are VECM, UBVAR, and BVAR, while at the twelve
month honzon they are VECM, BVAR, BVARD and UBVAR.
in
terms
of
out-
performing the random walk model. While BVAR, BVARD and TIBVAR
consisitently outperforms the random walk across all the forecast horizon in terms
of RMSE and U, BVECM always performs worse than the random walk forecasts
in terms of these descriptive statistics.
VECM and LVAR have shown mixed performance. VECM ou@erforms the
random walk model at all forecast horizon, except at the three month horizon.
LVAR outperforms the random walk forecasts only at one and twelve month
forecast horizon.
From the analysis of the descriptive statistics, it can be concluded that none of the
model performs best across all the forecast horizon. While VECM forecasts
occupies the first position
UBVAR occupies the top slot in three, six and nine month forecast horizon.
VECM forecasts are turning out to be efficient at one month ahead forecast
horizon, although there is no clearcut evidence on the unbiasedness of these
lorecasts at this horizon.
At
one month ahead forecast horizon, other models which includes ARIMA,
BVAR, BVARD and UBVAR, turning out to be unbiased in terms of nonparametric tests of unbiasedness.
2
It is worth to mention again that we use " Unrestricted Bayesian VAR " to point out the fact that in
121
All the forecasts satisfy the condition of unbiasedness and efficiency at three
month ahead forecast horizon. Although VECM performs very poorly in terms the descriptive statistics at this horrzon, efficient.
of
and
At
one month ahead forecast horizon, VECM forecast erors are statistically
different from all other model's forecast elrors including that of the random walk.
This evidence, combined with the fact that VECM has the minimum RMSE,
implying that it is significantly lower than the competing models. In terms of the information content test, also, it is the VECM which gives the best performance at the one month forecast horizon. VECM forecasts contained 'information' beyond those contained in other competing models including the
random walk.
corroborates our earlier hypothesis that VECM forecasts being unbiased and efficient, inspite of having very poor descriptive statistics, could only imply that is correctly predicting the increase/decrease of the exchange rate.
it
month forecast horizon. At one month ahead forecast horizon, VECM forecasts has an
edge over its competitors in terms of RMSE, Theil's U, Efficiency and Unbiased test,
this Bayesian VAR formulation we allow for the coefficients to vary across the country.
122
horizon,
Efficiency and Unbiased testg and direction-of-change analysis. Beyond three month
forecast horizon, one has to check the forecast output very carefully as there is no
clearcut evidence on the quality of the forecasts. This is not wholly rmexpected.
Forecasts of a furancial variable l1ke the exchange rate over the long frrecast horizon
I
123
Chupter
VII
Conclusion
The forecasting perfornance of exchange rate models has received
considerable attention since the breakdown of the Bretton Woods, when exchange rate began to float. The debate opened up with the work of Meese and Rogoff (1983),
models of exchange rate determination brought out the poor out-of-sample forecasting performance of the asset market models. In fact, the most serious result was that the
naiVe forecasts
asset
both
univariate and multivariate time series techniques with the aim of outperforming the
random walk model in terms of out-of-sample forecasting performance. We consider
model, sticky price monetary model, real interest differential model and HooperMorton model.
A11 these
they assume
that exchangerate is determined by the relative demand and supply of the two monies
as exchange rate is thought to be as nothing but the relative price of two monies.
It
is
t24
it.
We
exchange
rate, money supplies, interest rates and outputs as postulated by the monetary models
for
The next question that needs to be addressed is which version of the monetary model is supported by the empirical study. This could be determined by
signs
of
the variables in the cointegrating vector. Our empirical study supports the
produce good short and medium-run forecasts. Other multivariate models developed
are bayesian
are
Litterman (1979).
Four different bayesian VAR model have been developed. First is the bayesian VAR (BVAR) model which monetary model used
is
t2s
expected inflation and cumulative bilateral trade balance between India and USA as
in the
bayesian class
model
(BVECM) which incorporates the error correction term (with a flat prior on it) in the
BVAR model, where the error correction term is obtained from the cointegrating
relationship. Finally, we develop the unrestricted bayesian vector error correction (UBVAR) model. The term ' unrestricted ' has been used to denote the fact that we
have allowed the coefficients to vary across the countries in the bayesian framework.
That is, instead of assuming Minnesota prior on the coefficient of the, say, relative
money supply, we now assume the same prior on separate coefficients of the money
supply term of each country.
of
tests to assess the quality of the forecasts from the competing models. Among the
of
statistics like root mean square errors, Theil's U statistic, unbiasedness and efficiency tests, Diebold-Mariano equality
which outperforms all the models including the simple random walk model, while at
126
it is the unrestricted
bayesian
occupies the first position. Although beyond three month horizon, multivariate models
based
on
economic fundamentals as
model
outperforms the random walk forecasts in terms of the various descriptive statistics,
these forecasts do not seem to satisff the desirable properties
lead us to conclude that beyond the three month horizon one should interpret the
forecast results very carefully. We conclude here by noting down few limitations of the present study.
implicitly imposed the restriction of equal coefficienls between the domestic and
foreign country by working with relative money supplies, relative outputs and relative interest rates. This may be a very restrictive assumption. Because of our relatively small sample size, given by the post-liberalisation period, we are forced
to take this route to avoid degrees of freedom problem.
exchange rate
because of the absence of time series data on the three month treasury
India. Regular auction of the Indian three month treasury bill rate takes place from
January 1993 only.
t27
We also tried out call money rate in the case of India as the measure of the shortterm interest rate which gave us alarger sample size, that is, from August 1991 to
July 1999. However, we are unable to find any long-run equilibrium relationship
by using either M3 or
Ml
as the measure
Thus, it seems that the existence of the monetary model as a long-run equilibrium is not very robust to the choice of the variables included in the determinants of the fundamentals.
of
out the forecasting performance of the monetary models of the exchange rate
determination. Our prime motive was to obtain forecasts from the monetary models
of the exchange rate determination which beats the simple random walk
forecasts.
In future, we
would like to evaluate the forecasting performance of the portfolio balance models of
the exchange rute determination. Given the on-going research on the market
microstructure approach, we would like to model the agent's behaviour in the foreign exchange markets which would help us
to better
r28
Table: 1.1@)
(l)!t
(2)
d.o
* d.rta *
d.z(t
Tl2) + p1
y,
= a*o
*a*, !,-t*lt,
(2)
-2.2456
-1.7275
-2.1986
Bill Rate
-t.4379
-2.0032
Indian US IIP
Ml
-2.t257
-1.4693
-1.5310
-t.0721
-3.6085
-r.8529
-2.3792
Table : 1.2(A)
DICKEY-FULLER TEST
Time Period : February 1993 - Juty 1999
First Differences
Model
(3)
H (3)
Null Hypothesis
Test Statistic Exchange Rate
o:a, =0
tr1
Ho:a, =at =0
0,
a)
H
Q)
(1)
o:a, =0
tr$
4,q*r=
0,
Ho:ar=0
T
-2.5604 -2.1545
-2.3972
-t.6432
-1.1070
2.84s0
-2.4155
Ml
-3.2828
-2.4647 -2.7023
-2.t721
-2.6333
2.3637
3.5581
-2.1105
-2.6835
fable: 1.2(B)
PHILLPS.PERRON TEST
Time Period : February 1993 - Juty 1999
(1)
H
(2)
o:d, =1
o'.a*
=l
Z (td,)
4o.r)
-10.0100 -12.1010 -6.8330
-t0.3200
-12.2440
-6.8433 -7.7047 -10.6940 -9.8343
-7.7566
-9.9658 -9.8943
Ml
US CPI
US Treasury US
-7.4110
-7.3344
-7.3726 -4.0959
Bill
Rate
-7.7271
Ml
-4.3868
0,
xu
-3.43
0'
3.65 4.59 3.78
5%
ffi
6.25 5.34
-2.86 -2.s7
Significance
Level
Z (t
dr)
Z(t
a.
t%
5% 10%
-3.43
-2.86 -2.57
(3)
(2)
(2)
(l)
H
o:a, =a,
0,
2.2043
Ho"a,=0
xu
4:q-40, 2.6783
o:a, =0
T
-2.ttt7
-0.7423
0.1319
-2.7484
-2.0067
-1.1841
3.9054 2.3198
4.6t31
2.3766 3.6534
2.6064
-1.1770
-2.1418
-1.2796
Relative Money
t.t29t
-2.4556
TABLE :2.1(B)
(2)
o:d,
=l
H o:a* t
Z (td,)
-1.9434
R"lrt"- IP
Relative CPI Relative Interest Rate Relative Money Supply
fg,)
-1.568s
=l
-2.2603
-0.7545
-2.2526
-1.5205 -1.4638
-r.7250
(2)
(2)
-0
o:a, =0
1u
_::_
-3.0418 -2.0403 -3.3488 -5.0838
_0,
4.6279
4:q-'q=
0,
(t) H r:a, =0
__:_
2.6678
-1.2858
-2.7660
-2.1861 -3.3130
3.82s8 2.4977
2.s354
5.6113
s.4948
TABLE | 2.2(B\
=l
R.trt"- m
Relative CPI Relative Interest Rate Relative Money Supply
=l Z(t a.)
o'.a*
-12.1940
-6.666r
-7.93t8
-10.6130
Notes : All the variables are in logarithm term, except the relative interest rate. Exchange rate is the bilateral Indian Rupees / US Dollar exchange rate. Relative IIP is given by the logarithm difference of two country's Industrial Production Index. Relative CPI is given by the logarithm difference of two country's Consumer Price Index for industrial workers. Relative interest is given by the 3-Month Treasury Bill rate differential. Relative money supply is given by the logarithm difference of two country's money supply where Ml has been used as the measure of the money supply.
APPENDIX
Table : 1.1(A)
DICKEY.F'ULLER TEST Models:
p
(1)
!t =
at
!trtZO,t!y_l+i
i=2
+ZbiL y y_1*i
i=2 p
! t = ao + azt
+ at
(3)
(3)
(2)
(2)
(1)
Ho"a,=g
Hr"a, =s,
-0
o:a, =g
4:q:4=
H o'.a, =Q
c
_::_
-2.3064 Indian IIP Indian CPI Indian Treasury Bill Rate Indian
US IIP
_d,
3.2314
1.9739
__t,
0.2139 -1.7890 -0.9665 -1.8553
--!r2.4t66
6.2192 6.0261 1.7284 8.5396
2.2078
2.9411
3.2585
-t.448t
-2.8842
4.5t26
t.7200
3.8109
-t.8278
-2.0472 -2.1925
-0.4789
Ml
-2.5350
-0.4081
3.0340
8.1562
1
2.436t
2.0188
33.t250
65.5110
-t.3499
-1.0191
-t.6176
-1.8638 -1.8328
1.1750
2.3850 2.8041
2.3370
1.72s7
"0.73t6
-0.3056
Ml
-2.3681
Notes : IIP stands for the Index of Industrial Production CPI stands for the Consumer Price Index Number Treasury Bill rate is of the maturity period of 3-Months All the variables, except the treasury bill rate, are in logarithms.
\o
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.g *,
tt t{
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cl
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Table: 5.1.
Bayesian Unit Root Test (limit : 0.5, alpha : 0.8)
Schwarz
Limit
Marginal Alpha
0.9215
0.046
2.808
0.7316
0.9568
0.914
1.703 6.426
0.7170
0.3593 0.9727 0.9330 0.6219
0.2761
Indian
US IIP
Ml
0.t67
2.617
Bill
3.747 6.753
Marginal 0.2t91
0.9s02
0.5797 0.7818
5.644
0.591
Relative CPI
Relative Interest Rate Relative Monev S
9.7t4
7.014
8.514
3.t47 ly
2.737
, .
i'..
Tahle r 6
EnglrGrmgorTe*t'of Cofutegrafion
Sarnple Psrtod :
'::.
Jirriurry
1993
- July
1999
Test Type
Constant, No Trend
eonstant, Tremd
Dickey-Fuller
-3.3001
-2.3381.
No Coirrtegration
Phillips-Perron
-3.2383
-3.1413
No Cointqgration
- JuIy 1999
SBC (3)
AIC
(2)
LR
(4)
LM
(s)
4lags
-19.4383
-17.3371
3 lags
-19.5818
-t7.9747
21.2656 (0.168s)
No serial Correlation
2 lags
-19.7607
-18.6483
18.557
(0.2e23)
Serial Correlation
1 lag
-19.9292
-19.3112
t9.3664
(0.2s01)
Serial Correlation
Notes: (1) AIC stands for Akaike Information Criterion (2) SBC stands for Schwarz Bayesian Criterion (3) LR stands for the Likelihood Ratio Test Statistic (4) LM stands for the Langrange Multiplier test for Serial Correlation (5) In column (a) the value corresponding to 3 lags is the LR test statistic value for testing the null of 3 lags versus 4 lags. (p-values are given in the brackets below)
Table 8
Block-Exogeneity Test
Sample Period : January 1993
- JuIy 1999
in
25.3496 (0.003)
Relative IIP
20.$a6
(0.01s)
18.7968
(0.027\
30.3714 (0.0000)
Johansen-Juseliustl*;iation
Sample Period : 1993:01 - 1999:07
Test Resuu
s%c.Y.
t0% c.Y.
::6s.299s
s3.4800 49.9500
r-0
r<l
r<2
r<3
r)1
r>2
r>3
0.25635
29.7746
24.8700
31.9300
0.06584
7.2642
20.1800
17.8800
0.027t0
r=4
2.0883
9.1600
7.s300
Y""".
0.37339 0.25635
5% C.V.
t0% c.Y.
r=0
r=7
35.5249
28.2700
25.8000
r<l
r<2
r<3
r=2
r=3
22.5t04
22.0400
19.8600
0.06584
5.1759
15.8700
13.8100
0.02710
r=4
2.0883
9.1600
7.5300
Table : 10
.
Sample Period : January 1993
Cointegrating Vectsrs
- July 1999
(v- v. )
-2.4145
(i-i
(m-m')
1.0000
0.5409
0.0058 -t.3669
-r.2363
t.0000
2.5361
-0.3902
-7.8110
Note:Sisthebilateralspotexchangeratg
relative interest differential,
constant. * indicates
(*-*'
u
vl
s a'fr
vY-
=SE -i E $s F q;=
\i'#
a = 33
6) .E,
* ^n\S!c{
tsr
_ 3 Afr
q./
\i
.-
A\/{.'
-6!kE tstr.=
o
I (l)
-IEI
'o,
iT{E
F\
Hg,Fs.{-N
OO -
(rt
E]
THAR
\i,#
oo v la)
S
ro\ o\ o\
!
?ooX$ i!
$=r")i-
\*
o
o\ o\
(a
.i B $ E $ F$
g E gB !2 .E
(\l()./)a=5
o !+ $ n rr)
I
o E 6l a
o tr o F.r o
s E'Es E i EE H s E =,
6E
Table:
12
'
Simple Flexible Price Monetary Model with Log of exchanle rate,log of Relative UP, Relative 3-Months Treasury Bill Rates, and Log of Relative Money Supply given by Ml.
ffi
)'"=0.2
0.909792 0.916s19
7"
= 0.1
ffi
)u=0.2
0.891614 0.896867
ffi
l" = 0.1
)"=0.2
0.053768 0.0s4174 0.054s89
0.052029 0.052225
d:2.0
Priors
ffiffi
0.050991
0.051 130
l. = 0.1
ffi
?v=0.2
0.0s2747 0.053062
!t = ar !t_rtZO,tly_1+i
i=2
!t
= ao
* at !,-r
+ZbiL y y_t*i
i=2 p
!t =ao+azt*at !,_t+Ib,A
!-a
!y_r+i
(3)
H
(3)
(2)
(2)
(1)
,:a, =0
T1
Ho:a, =a,
0, 12834
2.5423
-0
o:a, =0
xu
4,%n=
Ho:ar=0
-2.5606 -2.1992
-3.6565
-2.5436 -t.7923
---ir3.23s1
1.6114
ffi
-1.0499
(2)
Z(t
Table:
14
Harmonic Lag
d:
Priors
t!!_
0.832412 0.843627 0.856376
l"
:0.1
]:!20.842t04
0.858704 0.873395
l. = 0.1
0.048835 0.049581 0.050431
_?u:0.2 0.049t49
0.050478 0.051632
l, = 0.1
0.049298 0.049953 0.050687
)v=0.2 0.049t02
0.0s0159 0.051063
AGF : LEVELS
1.5
u1
0
SF*OcD(oO)N
LAGS
PAGF : LEVELS
1.5
o
o-
IL
0.5
0 tOO)(Y)I-F
-0.5
LAGS
IL
o
-0.
-o.2
LAGS
lr
0.1
o
o-
0 -0.1 -0.2
LAGS
t..l
o
e.l
.,
qE=H+SqHqil
X
eX eX gs e.R e
\oo\ooroo
v-
aa
qRE$q9e$nS cOO.qO.aOc..lONO
vvvv
\o
SxEsE.E*i: 5= 5= -E
\o\oo\No\ cof-NO\ Nalra)+lr) $\f,cocon=
d3 es
O
CA
cq
co
oo
oo
T"T"?X
.+ \O $ tarcOOhcO ra) 00 @ @oooooooo ttttl
a FI iaa ri
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ta
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FS FA
il
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tr
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$H$FOr OOOOOO OOOOO
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9U!J(J(-)
r-+r-+r.)
&
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c.t ca
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c.t
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z (-)
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lj
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a L
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ts
cg
(J q)
ri
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CO
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tu
o
cl
15
(L)
&
o\ t-\o t+ o OC\ooC{O
tsOOOO OOOO-.;
r- o (\.1 o
(\t u)
o EI a
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(1)
q)
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C)
E*5s tuEr4
q)
q)
-A
Trble : 17
Summary Results of Unit Root Tests on Actuals and Predicted Series
Models/ Horizon
UBVAR
lStep
3 Steps
i.
Y
Y Y
i,
!'
6 Steps
9 Steps
Y
Y
12 Steps
Notes : "Y' stands for the non-rejeetion of the null of unit root. We employed Dickey-Fuller and Phillips-Perron unit root tests.
Table:
18
Models/
Forecast
ACTUALS
BVAR
EG, JJ EG, JJ EG, JJ
BVARD
UBVAR
Horizon
Step
EG, JJ
EG, JJ
EG, JJ
3 Steps
JJ
JJ
JJ
JJ
JJ
JJ
6 Steps
NOC
NOC
NOC
NOC
NOC
NOC
9 Steps
EG, JJ
EG, JJ
EG, JJ
EG, JJ
EG, JJ
EG, JJ
12 Steps
NOC
NOC
NOC
NOC
NOC
NOC
Notes : "EG' stands for the presence of cointegration by the Engle-Granger procedure. "JJ" stands for the presence ofcointegration by the Johansen-Juselius procedure. '\IOC" stands for no cointegration by either Engle-Granger or Johansen-Juselius procedure.
Table:19
Bias and Efficiency Tests of the Forecasts
Efficiency Test
(1
l1i1-E
ARIMA
10.0831
-t
r.7984
(0.180) 3.8779 (0.04e) 40.1989 (0.0000) 37.7419 (0.0000)
VECM
BVAR
BVARD
UBVAR
27.507t
(0.0000)
(0.0000)
Forecasts
,?
Bias Test
Efficiency Test
(1 -1) 0.0603 (0.806) 0.1002 (0.7s2) 0.3904 (0.s32) 0.3104 (0.s77) 0.1599 (0.68e)
l1-rg_
ARIMA
3.562s (0.168) 3.0312 (0.220) 8.5920 (0.014) 8.1199 (0.017) 8.5609 (0.013)
VECM
BVAR
BVARD UBVAR
- _1.3Fq!!:]iw:tr
Teble 19.3
-r)
8.7265 (0.013) 14.4646 (0,001) 12.1932 (0.002) 12.2484 (0.002) 12.4788 (0.002) 7.0984 (0.00s) 17.!,47g (0.000)
15.6964
ARIMA
VECM
BVAR
(0.000)
BVARD
r6.0102
(0.mm)
16.0?48
UBVAR
(CI.0m)
Table:20
Nonfarametric Test of Unbfusodness
Models
:'i1"':
t2
ARIMA
202
VECM
20
413
BVAR
BVARD
11
209
11
197
TJBV'AR
11
213
Notes : (1) Reject the null of median urfiiasednese,at 5yo significsnce level if th calculated value of the sign statistic is less than equal to 9.993 or if S is greater thar equal to 21.007. (2) Reject the null of median (= mean) unbiase&ess if the calculated valuo of the Wilcoxon rank sum test statistic exceds 348 or if it is less than 148.
Table :21 Diebold-Mariano Test for Equality of Mean Square Errror One-Month Ahead Forecasts
Models SRW ARIMA VECM BVAR BVARD
ARIMA
VECM
BVAR
BVARD
UBVAR
-3.7199.
-3.8118
0.9002 -0.3231
3.9532.
@
0.1433 4.0129 * 1.8756 1.5758
ARIMA
VECM
-a8642
-1.0256
BVAR
UBVAR
-0.7681 0.4857
ffi
ARIMA
ffi:
ARIMA VECM BVAR BVARD
VECM
BVARD
ffi
03884
-1.0748 -0.1908 0.1338
-0.3045
Table 21 (Gontd..)
ARIMA
VECM
BVAR
BVARD
SRW:
ARIMA VECM BVAR BVARD
3.6993.
03769
0.1815
ffi
-1.0851 -1.6305
ffi
ARIMA
VECM
BVAR
BVARD
UBVAR
1 .0159 0.5495 -0.4312 1.4971 1.7156
Tssz
ARIMA VECM BVAR BVARD
ffi
0.5192
ffi
Table:22
lnformation Content Test
One-Month Forecast Horizon Dependent Variable : Actual
Independent Variables
Constant 0.0014 (0.6888) (0.4e66) 0.0089 (1.4e43) (0.1463) 0.0094 (1.s200) (0.13e7) 0.0093 (1.3406) (0.1908) 0.0069
ARIMA
0.1495 (0.33s8) (0.73es) 0.4873
VECM
0.7783 (2.0128) (0.0538)
BVAR
BVARD
UBVAR
(1.zete)
(0.2069) 0.5006 (1.3468) (0.1 888) 0.5076 (1.24s4) (0.2233)
0.9232 (2.7s42) (0.0102) 0.9499 (2.8183) (0.0088) 0.9s94 (2_e020) (0.0071)
(-t.ts73)
(o.2s6e) -t.1273 (-0.e106) (0.3702)
-1.2573
(r.66e0)
(0.1083) 0.0077 (1.71e8) (0.0e65) 0.0086 (1.s482) (0.1328) 0.0102 (1.ss21) (0.131e) 0.0087 (1.2248) (0.230e) 0.0082 (1.1646)
(-1.se13)
(0.1,228)
-1.5857 (-1.50e6)
(0.t424)
-1.7207
(-r.4003)
(0.1724)
(0.2s40)
r31)
Table 22 (Contd..)
ARIMA
VECM
-0.1061
BVAR
BVARD
UBVAR
ffi
(-0.5018) (0.6200) 0.5857 (0.ee82) (0.3273) 0.5990
(-t.6643)
(0.1081) -1.7209 (-2.3706) (0.0255)
(2.r448)
(0.041s) 0.0455 (2.0628) (0.04e3) 0.0392 (2.1 880) (0.0378) 0.0408 (2.3s08) (0.0266) 0.0464 (2.137T) (0.0422) 0.0424 (3.37es) (0.0023) 0.040s (2.1064) (0.04s0)
0.0361
(0.e4t4)
(o.3ss2)
0.5183
(0.es8s) (0.3467)
-24.4491
(-2.ts78)
(0,0404) -0.3179 (-0.1837) (0.40s1)
-t.3042 (-0.8462)
(0.4s01)
(1.8258) (0.07e5)
1.0069
(0.7022) (0.4888)
Table 22 (Contd..)
ARIMA
-1.1424 (-1.312s) (0.2023) r.6287 (1.5s80) (0.132e) 1.5493 (1.440s) (0.1632)
1.8545
VECM
-0.1914 (-0.4604) (0.8481)
BVAR
BVARD
UBVAR
(2.6se)
(0.0140) 0.0638
(2.e64s)
(0.006e) 0.0658 (3.0e8s) (0.00s1) 0.0905
(4.26t0)
(0.0003) 0.0726 (4.0468) (0.000s)
(1.7726) (0.08es) 0.3421 (0.8661) (0.3e80) -1.6658 (-4.515) (0.0002) -1.787s (-4.3368) (0.0002)
-2.8901 (-6.s024)
(0.0000)
0.074t
(4.2e83) (0.0003) 0.0970 (s. l 63s) (0.0000) 0.0798 (s.6582) (0.0ooo) 0.1078 (3.68s3) (0.0012) 0.0888 (3.47ss) (0.0020)
0.34t7
(0.8736) (0.3e13) 0.3716 (0.8e36) (0.3808)
-2.5138
(-4.tt78)
(0.ooo4)
10.311l (1.se63)
(0.r24r)
0.9375 (0.4123) (0.683e)
Table 22 (Contd..)
ARIMA
VECM
-0.2358 (-0.4777) (0.6380)
BVAR
BVARD
UBVAR
+8477
(-2.003) (0.0s8e)
(t.4s7L)
(0.1606) 1.0816
(-6.st76)
(0.0000)
(2.t6tt)
(0.0430)
0.1 555
(6.41s6)
(0.0000) 0.1031 (8.3285) (0.0000) 0.1513 (12.1683) (0.0000) 0.1162 (1 1.8887) (0.0000) 0.1496 (e.22e2) (0.0000) 0.1398
(-4.7r37)
(0.0001)
-1.4346
(t.6672)
(0.1111) 0.0275 (0.367e) (0.7168)
(-1r.5s36)
(0.0000)
(s.6826)
(0.0000)
(-0.73re)
(0.4727)
Table 22 (Contd..)
ARIMA
-L7541 (-2.se{e)
(0.018e) -0.3219 (-0.4062) (0.68e7) -0.7243 (-0.8827) (0.38e7) 0.4023 (0.s142) (0.6137)
VECM
-0.4574 (-1.337s) (0.1e87)
BVAR
BVARD
UBVAR
-0.9909
(-4.43ss)
(0.0004) -0.9809 (-e.0422) (0.0010)
0.ts29
(6.0033) (0.0000) 0.1903 (8.51e2) (0.0000) 0.1459 (6.6686) (0.0000) 0.1517 (6.3306) (0.0000) 0.1901 (8.2e84) (0.0000) 0.1358 (11.8763) (0.0ooo) 0.2884 (6.0e5e) (0.0000) 0.2595 (6.8064) (0.0000
(-s.034s) (-s.034s)
-0.6921 (-4.6921) (0.0002) -1.9096 (-s.304e) (0.0001)
-5.1222
4.2983
(r.e6o2)
(0.0666) -5.9470 (-3.s180) (0.0026) -4.8945 (-3.8887) 0.0012
(2.s62t)
(0.0202)
t.9664 (2.71e8)
(0.0146)
Table : 23
Direction - of - Change Analysis
One-Month Three-Month Six-Month Nine-Month 0.6628 alg44 1.2468 0.1406 0.7484
0.0000 0.0000
1.6155
Twelve-Month
0.0553 0.1169 0.0000 0.0000 0.0000
ARIMA
VECM
2.581t',
0.0000 0.0000
2.6966b
0.5312
0.1406 0.0000 0.0000
BVAR
BVARD UBVAR
Notes : (1) Entries in the cell are calculated chi-square statistic with 1 degrees of freedom. (2) Critical value of the chi-square statistic with I degrees of freedom atl}Yo significance level is 2.7 l. (3) * indicates that the statistic is significant at lloh significance level. (4) uindicates that the statistic is significant at 10.08o/o significance level, bindicates that the statistic is significant at 10.06% significance level.
Bibliogruphy
November,
and
walk ? ", unpublished mimeo, M.Phil. Applied Term Paper, Delhi School of
Economics.
forecast accuracy of various models ", unpublished mimeo, Term paper (M.A.),
San Francisco,
macroeconomists should know about unit roots ", National Bureau of Economic
Research Inc. Working Paper No.100,
April.
and
Evidence from the Canadian float of the 1950s ", Joumal of Macroeconomics, Vol.19, No.2, Spring, p.349-362.
square forecast
" Testing for market timing ability : A Journal of Financial Economics, Vo1.19,
:"
: "
Reconsidering
'
approach to the
: Long-run
: "
autoregressive time series with a unit root ", Econometrica, Vol.46, No.4, June,
:"
1n
Diebold, F.X.. and J.A.Lopez (1996): " Forecast evaluation and combination ", in Handbook of Statistics, ed. by G.S.Maddala and C.R.Rao.
Doan, T.A. (1990), Regression Analysis of Time Series lJser's Manual. Estima,
Illinois.
Dornbusch, R. (1976) : " Expectations and exchange rate dynamics ", Joumal
of
I 61 -7 6.
",
p.223-237.
econometric models ", American Economic Review, Vo1.80, No.3, June, p.375-89.
phenomenon ", Joumal of Intemational Money and Finance, Vol.5, June, p.181-93.
monetary model ", Review of Economics and Statistics, Vo1.64, August, p.515-19.
determination " in Exchanse rate theory and practice, ed. by John F.O.Bilson and Richard C.Marston (Chicago : University of Chicago Press).
'
",
",
Scandinavian Journal
of Economics, Vol.78,
No.2, p.200-224.
the
Johansen-Juselius
performance
models of exchange rate determination : An empirical examination ", Journal Monetary Economics, Vol.11, March, p.247-60.
of
nominal and real exchange rate determination ", Journal.of Intemational Money
and Finance, Vol. 1,
dollar vis-d-vis the US dollar using rnultivariate time-series models ", Applied
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