Real Exchange Rates and Fundamentals in a new Markov‐STAR Model*
| Published date | 01 April 2022 |
| Author | Philip Bertram,Teresa Flock,Jun Ma,Philipp Sibbertsen |
| Date | 01 April 2022 |
| DOI | http://doi.org/10.1111/obes.12467 |
Real Exchange Rates and Fundamentals in a new
Markov-STAR Model*
PHILIP BERTRAM,†TERESA FLOCK,†JUN MA‡and PHILIPP SIBBERTSEN†
†School of Economics and Management, Institute of Statistics, Leibniz University Hannover,
K¨
onigsworther Platz 1, Hannover D-30167, Germany (e-mail: sibbertsen@statistik.
uni-hannover.de)
‡Department of Economics, College of Social Sciences and Humanities, Northeastern
University, 301 Lake Hall, 360 Huntington Avenue, Boston, Massachusetts 02115, USA
(e-mail: ju.ma@northeastern.edu)
Abstract
We propose a new nonlinear Markov-STAR model to capture both the Markov
switching and smooth transition dynamics for real exchange rates. We derive
stationarity conditions for the model and apply it to the real exchange rates of 17
countries. We relate switching equilibrium rates and volatilities to a set of relevant
macroeconomic variables and find, consistent with economic intuitions, that an
economy deteriorating relative to the US economy tends to see a significantly
increased likelihood of real exchange rate depreciation. Moreover, we document
significant connections between rising economic uncertainties and real exchange rate
changes as well as exchange rate volatility.
I. Introduction
In this study, we model the time-varying equilibrium as well as the nonlinear
adjustment process to the equilibrium of real exchange rates, and link the changing
exchange rate equilibrium to economic fundamentals. This approach therefore
combines two important features from two major streams of literature modelling real
exchange rates: one that focuses on the time-varying equilibrium real exchange rate,
albeit in a linear model, and the other that stresses nonlinear mean-reversion but with a
constant equilibrium real exchange rate.
Specifically, we introduce a new nonlinear Markov smooth transition autoregressive
(Markov-STAR) model to capture both Markov switching (MS) and smooth transition
dynamics in real exchange rates. The MS part is modelled using a discrete latent factor
and captures the time variations of equilibrium exchange rates and their volatilities,
JEL Classification numbers:C22, C51, F31.
*We gratefully acknowledge the support of the Deutsche Forschungsgemeinschaft under grant SI 745/9-1. The
helpful comments of Christian Conrad, Timo Terasvirta, Rolf Tschernig, the editor Jonathan Temple, two
anonymous referees and the participants of the SNDE 2016 meeting are gratefully acknowledged.
356
©2021 The Authors. Oxford Bulletin of Economics and Statistics published by Oxford University and John Wiley & Sons Ltd.
This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivsLicense, which permits use and
distribution in any medium, provided the original work is properly cited, the use is non-commercial and no modifications or adaptations are made.
OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 84, 2 (2022) 0305-9049
doi: 10.1111/obes.12467
whereas the smooth transition part models nonlinear adjustment of the real exchange
rate to the switching equilibrium rate. The discrete MS factor is particularly useful to
model sudden but persistent regime changes present in the real exchange rate data. We
derive stationarity conditions for the model, outline the estimation algorithm and apply
it to the real exchange rates of 17 countries. We show that this model provides a
useful complement to a model that features either MS or smooth transition dynamics
alone.
The switching equilibrium rates should reflect the underlying changing economic
fundamentals. Therefore, we relate the switching equilibrium rates and volatilities to
relevant macroeconomic variables, including the output gap, inflation rate and
economic uncertainty. We document a number of findings that are broadly consistent
with standard economic models. First, an economy deteriorating relative to the US
economy tends to see a significantly increased likelihood of real exchange rate
depreciation relative to the US dollar for most countries in our study. Second, higher
economic uncertainty in the United States increases the likelihood of real exchange
rate appreciation significantly in many advanced European economies, whereas
exactly the opposite is true for some developing countries. Finally, rising economic
uncertainty tends to be associated with higher exchange rate volatility across the
board.
As such, this study’s purpose is twofold. The first is to propose a new nonlinear
Markov-STAR model to better capture both types of nonlinear dynamics in real
exchange rate data. The other is to further study the connection between the real
exchange rate and economic fundamentals through the lens of this new model. The
latter makes another important contribution to the literature that has attempted to
relate exchange rates to a set of economic fundamental variables in standard
economic models (see Engel and West, 2005). Although some previous work has
presented supportive empirical evidence in this regard (see Rapach and Wohar, 2002;
Cerra and Saxena, 2010), such a close connection is not conclusive (see Bacchetta
and van Wincoop, 2013). To the best of our knowledge, our work is the first to
study the connection between the equilibrium real exchange rate and economic
fundamentals in a highly nonlinear model. Our empirical findings suggest a stronger
connection than has been documented in the literature based primarily on linear
models.
The remainder of the paper is organized as follows. Section II reviews the literature
and compares it with our work. Section III presents an economic motivation.
Section IV describes the proposed model. Section V discusses some specification
issues for the model, and section VI outlines the estimation of the model parameters.
Section VII applies the model to real exchange rate data, and section VIII concludes.
II.Literature review
This section provides a brief review of the literature that has studied nonlinear
exchange rate dynamics and the relationship between exchange rates and economic
fundamentals. Intuitively, the tendency for the real exchange rate to revert to its
equilibrium value becomes stronger only when it is further away from the equilibrium
©2021 The Authors. Oxford Bulletin of Economics and Statistics published by Oxford University and John Wiley & Sons Ltd.
Real exchange rates and fundamentals357
Get this document and AI-powered insights with a free trial of vLex and Vincent AI
Get Started for FreeStart Your 3-day Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your 3-day Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your 3-day Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your 3-day Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your 3-day Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting