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I am grateful to Carlo Cottarelli, Juha Kähkönen, and Murat Üçer for helpful discussions and comments. The opinions expressed in this paper are those of the author and do not necessarily reflect the views of the IMF.
This assumption has no implications for the determinants of the long-run relationship that is sought in this paper.
The assumption of a balanced budget results in households doing all the borrowing in the economy. The reduced form does not depend on who borrows; this assumption just keeps the model simple.
Of course, this assumption is not strictly true for the Finnish economy, given the large cyclical component of unemployment. However, the long-run results are not affected by this assumption. For a different implementation, see Obsfeld and Rogoff (1995a).
This definition differs from the real exchange rate in the theoretical section. For simplicity this paper concentrates on the CPI-based real exchange rate rather than that based on the relative price of tradables and nontradable goods or on the relative unit labor cost. For a detailed analysis of the difference between these definitions, seeLipschitz and McDonald (1992) and Hinkle and Nsengiyumva (1996).
The theoretical section emphasized the productivity difference between the tradable and nontradable sectors, but such data are not readily available. The productivity measure, and the expected effect on the exchange rate, still hold, given the definition of the real exchange rate.
Another structural change, the liberalization of the capital account, has occurred within the sample. However, the changes were spread over several years; more importantly, there are indications that the restrictions were not binding even prior to their removal (see Kovanen 1995). Therefore, this structural break is not modeled.
In all the tabulations, three stars means that the test statistic is significant at 1 percent probability, two stars at 5 percent probability, and one star at 10 percent probability.
The results do not change when a break in 1991 is considered.
The results are obtained by using Eviews and PcGive econometric software packages.
The unadjusted figures are also shown to give a sense of the lack of power that is due to a small sample.
This test is conducted jointly with the trend variable because the trend in the cointegrating equation was included only to model the trend in the productivity variable. If productivity is not included, the trend should not be included in the cointegrating vector either.
The figures in parentheses are standard errors. All t-statistics are significant at 5 percent probability. Also, for the regression, R2 = 0.81, and F-statistic = 38.48 with prob(F-statistic) = 0.00.
The sharp decline in the estimated long-run exchange rate is partially due to the dummy variable set to switch in 1991, to capture the collapse of trade with the Soviet Union. Even though the largest one-time decline is in 1991, signs of weakening trade were present earlier. Since a smooth dummy is not used, the equilibrium exchange rate could have been overestimated just before 1991.