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This paper has benefited significantly from comments by several colleagues in the European I and Research Departments, and participants in a seminar at the European Central Bank.
This is consistent with the appreciation of the dollar against currencies other than the euro of about 25 percent over this period, which would translate into a decline in the euro’s effective value of about 10 percent given the dollar’s weight.
Covered interest parity requires that the interest differential equal the gap between the forward exchange rate quoted in futures markets and the spot rate. The difference between the expected future rate and the forward rate then corresponds to the expected excess return.
The standard deviation of annual exchange rate movements among large industrial countries is, on average, five times greater than that of interest differentials (Meredith (2001)).
A more detailed discussion of these conceptual issues is contained in IMF (1998). Adding sticky-price dynamics via an inflation equation would not alter the underlying story.
As discussed in the next section, this effect depends on the source of the productivity shock. A shock concentrated in the traded-goods sector could instead lead to exchange rate appreciation via Balassa-Samuelson effects.
Net oil imports of the euro area were about 0.7 percent of GDP in 1998 compared with 0.5 percent for the U.S.
Growth could also affect the current exchange rate through its impact on the expected long-term real exchange rate. A monetary shock, however, would not be expected to influence long-term real variables, including the exchange rate.
Similarly, regressing the change in the yield on index-linked French government bonds on that in the policy interest rate yielded a coefficient of 0.064 with a t-statistic of 1.3, indicating that real long-term interest rates tend to rise when monetary policy is tightened.
Bailey and others (2001) have a lucid discussion of these effects in the context of a stylized model.
The “adjusted” yield spread reflects the increase in the spread between yields on U.S. corporate bonds and treasuries, and is intended to adjust for the effect of a reduced supply of treasuries on market yields in 1999-2000 (see Schinasi and others (2001)).
Measures of inflation expectations from consensus forecasts and, more recently, break-even inflation rates from index-linked bonds, suggest that longer-term expectations were indeed relatively stable over this period.
These phenomena are also consistent with another facet of the “new economy” story: that high returns on U.S. investment have attracted foreign capital, driving up the exchange rate through capital account effects. Indeed, balance of payments data show a rise in direct investment by euro-area residents in the U.S. in recent years. Furthermore, empirical studies indicate a significant correlation between these capital flows and exchange rate developments (IMF (2001), Chapter II).
DeBroeck and Slak (2001) find, for instance, an average response of the real exchange rate to GDP growth of 0.4 for non-transition countries. Bailey and others (2001) simulate a stylized model to derive roughly the same ratio of exchange rate movements to productivity changes.
Sinn and Westermann (2001) question the role of equity prices in explaining exchange rate movements from a portfolio balance perspective. The channels advanced here, however, are not based on portfolio effects, but rather the impact of equity price movements on aggregate spending and thus on interest differentials. Indeed, assets in different currencies are assumed to be perfect substitutes in the model.
See Edison and Sløk (2001a). Theoretically, this phenomenon would be consistent with non-U.S. households having a lower discount rate on future labor income. Changes in financial wealth would then represent a smaller proportion of overall household wealth, implying a correspondingly smaller marginal propensity to consume out of wealth. More prosaically, U.S. equities could tend to be held directly by households, while in Europe equities may tend to be held more in trusts, pension funds, and indirectly through other financial intermediaries.
Beyond 2000, the shocks were calculated to keep the ratios of equity market capitalization to GDP constant at their new, higher, levels.
This effect is discussed by Summers (1981) in the context of U.S. corporate taxation. He observes that equity values will rise by more when taxes fall if investors do not foresee the effects of capital accumulation on the marginal productivity of capital.
The baseline value is similar to the 6.1 percent figure estimated for the U.S. by Mehra and Prescott for 1889-1978. Epaulard and Pommeret (2001) estimate premia ranging from 1.5 to 6.5 percent for France, judging the higher figure to be more representative.
The simulated rise in U.S. labor productivity growth of about ½ percentage point per year is similar to Nordhaus’ (2001) estimate an acceleration in U.S. productivity (outside the technology sector) of 0.54 percentage points during 1995-98.
The intertemporal elasticity of substitution in consumption was changed to ¼ from its baseline value of 1, while the production elasticity was changed to ½ from 1. With these values, the real short-term interest rate in the U.S. rises by 3 percentage points above baseline by 2000, as opposed to slightly over ½ percentage point in the base-case scenario.
The magnitude of the rise depends on the elasticity of substitution between capital and labor in production and the intertemporal elasticity of substitution. With logarithmic utility and Cobb-Douglas production technology, as assumed here, the steady-state real interest rate rises by the same amount as the increase in productivity growth.
A two-sector framework that allowed for Balassa-Samuelson effects would be more likely to work in the right direction in terms of the exchange rate, but would encounter problems with other stylized facts, as discussed earlier.
An example is French and Belgian pension funds, which are required by law to maintain at least 80 percent of their portfolio in domestic-currency assets.
For this shock the relative size of the two areas was reversed so that the ROW, now interpreted as the euro area, accounted for 1/3 of total output. The shock was implemented by introducing a constant ε into the uncovered interest parity condition for the exchange rate (equation (1) in the text or (A.30) in Annex A).
See Edison and Sløk (2001a) for a discussion of recent estimates. For North America and the UK, they estimate an average MPC of 0.052 out of equity wealth in traditional stocks, and 0.040 out of “new economy” stocks.