Abstract
This Selected Issues paper and Statistical Appendix examines inflation and wage dynamics in Finland. The paper discusses the data set used (quarterly data covering from 1975 to 1995) and the statistical properties of the relevant time series. It presents the model and the empirical estimates, and provides an outlook for consumer price index and nominal wage inflation for 1996:Q1–2001:Q4. The paper examines the determinants of the equilibrium real exchange rate, and also analyzes the Finnish banking system and the credit crunch hypothesis.
II. The Determinants of the Equilibrium Real Exchange Rate: An Application to Finland 1/
1. Introduction and summary
The real effective exchange rate for Finland has been subject to large swings in recent years (Chart 6). Starting in 1986, for instance, the GPI based rate has first appreciated by some 15 percent, then depreciated more than 30 percent, and since 1993 appreciated by approximately 20 percent. This pattern holds whether the real exchange rate is measured using relative CPIs or relative unit labor costs.
FINLAND: REAL EFFECTIVE EXCHANGE RATES, 1975–1996
(In logs)
Citation: IMF Staff Country Reports 1996, 095; 10.5089/9781451813128.002.A002
Source: PDR, Information Notice System.FINLAND: REAL EFFECTIVE EXCHANGE RATES, 1975–1996
(In logs)
Citation: IMF Staff Country Reports 1996, 095; 10.5089/9781451813128.002.A002
Source: PDR, Information Notice System.FINLAND: REAL EFFECTIVE EXCHANGE RATES, 1975–1996
(In logs)
Citation: IMF Staff Country Reports 1996, 095; 10.5089/9781451813128.002.A002
Source: PDR, Information Notice System.What are the reasons for these swings? And to what extent are they related to a shift of the equilibrium exchange rate rather than to (temporary) shifts away from equilibrium? Of course, it can be argued that at any moment the exchange rate is an outcome of an equilibrium between supply and demand, particularly if the exchange rate is floating, and therefore there can be no misalignment. But this in itself does not guarantee that a particular exchange rate is sustainable in the long run. Therefore it is important to be clear about what we mean by equilibrium: following other studies (e.g. Williamson (1994), Edwards (1994), Montiel (1996)) we define the equilibrium real exchange rate, ERER, as the rate that is sustainable in the long run, i.e., consistent with both internal and external long run macroeconomic balances. The level of such an equilibrium is especially relevant for the possible entry of the markka in the ERM: if the nominal exchange rate is fixed at a level for which the real exchange rate is in disequilibrium, the adjustment will require changes in domestic prices with respect to foreign prices, with potential short-term real effects.
This chapter is an attempt to estimate the factors affecting the equilibrium exchange rate in Finland. The model used is based on the equilibrium exchange rate theory developed in Montiel (1996). The fundamentals that determine the equilibrium exchange rate (which in turn is determined by the internal and external balances) are the terms of trade, world real interest rates, the productivity differential, trade policies, and government spending. The theory implies a reduced form that links the equilibrium to the fundamentals. We empirically examine this reduced form, in the spirit of Edwards (1994). In our analysis, given the nonstationary nature of the variables, we use cointegration techniques introduced by Johansen (1988 and 1991). This method has the advantage of defining a relationship between the real exchange rate and its determinants that is valid in the long run, even though there may be large deviations from equilibrium in the short run.
We find that during the sample period the equilibrium real exchange rate appreciated (depreciated) in response to positive (negative) shocks in the terms of trade, world real interest rates, and the productivity differential between Finland and its trading partners. The short-run movements were also affected by the price differential between Finland and its trading partners, and by the deviations from the uncovered interest parity. The implied equilibrium exchange rate is quite stable between 1976 and 1985, during which the effects of the terms of trade shocks are mitigated by interest rate and productivity shocks. The equilibrium exchange rate appreciates between 1986 and 1990, primarily due to very favorable terms of trade. With the collapse of trade with the former Soviet Union and the deterioration of the terms of trade in the early 1990’s the equilibrium exchange rate depreciates substantially. As the nominal exchange rate is kept unchanged, the markka stays overvalued for more than two years. However, after the markka was floated in September 1992, there seems to have been a long episode of an undervalued markka. The misalignment is estimated to have virtually disappeared in 1995, and projections suggest that the equilibrium real exchange rate is likely to remain close to its present level in the medium term.
The second section briefly describes the theory of the equilibrium exchange rate. The effects of fundamentals on the exchange rate are also discussed. The third section is devoted to the key empirical issues: the properties of the data, the cointegration method, the cointegration results and tests, and the implied long-run equilibrium and short-run dynamics.
2. Theory
There is a wealth of theoretical and empirical work on the determinants of the equilibrium real exchange rate. One important strand of literature is associated with Williamson’s seminal work (Williamson 1985) that has its roots in an approach developed by IMF staff (Artus 1977). 1/ Williamson defines the fundamental equilibrium exchange rate, FEER, as the rate that “would produce a current account (at internal balance) consistent with the expected saving-investment behavior of both private and public sectors”. 2/ In order to determine the FEER, it is first necessary to formulate an econometric model for the trade sector that captures the relationships among output, balance of payments, demand and competitiveness. Second, internal balance is defined, usually as the level of economic activity that keeps the inflation rate constant. Third, a normative current account target is chosen by paying particular attention to past imbalances.
The FEER is then calculated as the exchange rate that maintains equilibrium in both sectors, given the projected output, current account and trade balances, and capital flows. A critical summary of this approach by Black (1994) points out that the policy mix to achieve internal balance, the timing of the implementation of that policy mix, and the target for the current account balance remain serious questions.
An alternative approach, followed in this chapter, is to investigate the equilibrium exchange rate by looking at the reduced forms implied by a theoretical model. The theoretical model is based on the long-run equilibrium real exchange rate model by Montiel (1996)—see also Khan and Montiel (1996). Similar to Williamson’s approach, the long-run ERER is defined as the level that is consistent with simultaneous internal and external balance. In addition, a set of exogenous “fundamental” variables are defined. These variables determine the internal and external balances, and thus the long-run equilibrium exchange rate. The reduced form constructed between the exchange rate and the fundamentals lets us investigate the nature of the equilibrium. One major difference with respect to Williamson’s approach is that in this approach, there is no need to decide what the appropriate level of current account balance and the external net position should be: they are endogenous to the system.
a. The model
The model is an extension of the two-good small open economy model by Dorribush (1974). The real exchange rate is defined as the relative price of nontraded goods in terms of traded goods, and the nominal exchange rate is assumed to be fixed. 1/ The model consists of producers of traded and nontraded goods, representative households that maximize their discounted utility functions, and a consolidated government with a balanced budget. 2/
The producers, households and the government are modeled as follows. The producers are price takers in the world market. Output is produced with a fixed, sector specific input and homogenous, perfectly mobile labor. 3/ Firms in both sectors maximize profits by setting the marginal productivity of labor to the wage rate. The representative household maximizes current and discounted future consumption of traded and nontraded goods, subject to the budget constraint. Each period, the household decides to allocate its the budget constraint. Each period, the household decides to allocate its net worth between foreign bonds that pay a nominal interest rate i*, and domestic money that reduces the transaction cost of consumption. The public sector consists of the government and the central bank. The central bank exchanges currency and passes the interest receipts on the foreign bonds it holds to the government. The government keeps a balanced budget, with lump-sum taxes and purchases of traded and nontraded goods. Regarding external borrowing, the arbitrage condition dictates that the country can borrow with a risk premium that is determined by the country’s international indebtedness.
The model, when solved, implies an external and an internal equilibrium condition. External equilibrium is attained when the level of consumption and the real exchange rate lead to a sustainable current account balance:
where π* is the world inflation rate, a* is the net foreign assets of the country, yT(e) is traded goods output, e is the real exchange rate (relative price of nontraded to traded goods), 1/ i* is the nominal domestic interest rate, τ* is the transaction costs associated with consumption, θ is the (constant) share of traded goods in total private consumption, and gT is government consumption of traded goods. The nominal interest rate is determined by the world nominal interest rate iw and a risk premium that depends on the international asset position of the country. In this equilibrium, the trade surplus is equal to (yT(e) - (τ* + θ)c - gT). Interest receipts are equal to net foreign assets times the interest rate: i*a*. The two components added up give the current account balance as the right hand side of equation (1). The left hand side shows the portion of net foreign assets that lost its value due to inflation. The equilibrium implies that the sustainable current account amounts to the inflationary erosion of the real value of net foreign assets. Put differently, a sustainable trade deficit must equal the real return on the net foreign assets that depends on the real world interest rate and the risk premium as well as the stock of net foreign assets. Since traded goods output depends inversely on the exchange rate, to sustain the equilibrium, as exchange rate appreciates, consumption of traded goods (as well as total consumption, as 0 is constant) has to fall. This trade off is depicted in Chart 7 as the external balance locus (EB).
Internal and External Equilibrium
Citation: IMF Staff Country Reports 1996, 095; 10.5089/9781451813128.002.A002
Internal and External Equilibrium
Citation: IMF Staff Country Reports 1996, 095; 10.5089/9781451813128.002.A002
Internal and External Equilibrium
Citation: IMF Staff Country Reports 1996, 095; 10.5089/9781451813128.002.A002
Internal equilibrium is defined by the nontraded goods market:
where yN is nontraded goods production, positively related to the exchange rate, and gN is government consumption of the nontraded good. Given the consumption decisions of the households and the government, this condition defines the equilibrium real exchange consistent with nontraded goods market clearing. An appreciated exchange rate increases the production in the nontraded goods sector. This, in equilibrium, requires an increase in consumption, and this relationship is captured with the internal balance (IB) locus in Chart 7.
Equations (1) and (2) express an equilibrium condition tat must hold in the long run. Chart 7 depicts this equilibrium as the point where the two loci intersect. Of course, the two loci in turn depend on variables that we call fundamentals. A change in the fundamentals changes consumption and the real exchange rate. These fundamentals are discussed in the next section.
b. Effects of changes in the fundamentals
In this section, we describe how the fundamentals affect the equilibrium exchange rate, starting with real world interest rates. An increase in the world real interest rate increases the local interest rate, and decreases the demand for money, raising savings and improving the current account balance; to restore external equilibrium a real appreciation is needed. Moreover, if the country is a net creditor in the international markets, interest receipts increase, and the external balance locus also shifts up involving an increase in consumption and an appreciation of the ERER. On the other hand, if the country is a net debtor in the international markets, as is the case for Finland, the interest payments on existing debt go up. However, as long as the effect of interest payments does not dominate the effect of increased saving, the external balance locus still shifts up even if a country is net debtor. In conclusion, an increase in interest rates leads to an appreciation of the real exchange rate unless the country is net debtor and the saving propensity is not much elastic to interest rates.
The terms of trade also affect the equilibrium exchange rate. To see this, the model can be modified by splitting tradables into exportables and importables, with the real exchange rate redefined as the price of nontradables in terms of importables. A positive terms of trade shock (an increase in the price of exports relative to the price of imports) causes the output in the nontradables to decline, creating an excess demand in the nontraded goods sector, and shifting the internal equilibrium locus up. At the same time, the external equilibrium locus shifts up as well, reflecting the necessity to have an appreciated exchange rate in order to maintain the sustainable trade balance. Thus, the new equilibrium requires an appreciation of the real exchange rate.
Productivity differentials also influence ERER. An increase in the productivity of the traded goods sector relative to the nontraded goods sector results in an expansion of the traded goods sector at the expense of the nontraded goods sector. Similar to a positive terms of trade shock, such a shift creates an excess demand for nontraded goods, which can be eased by a real appreciation of the exchange rate. This implies an upward shift of the internal equilibrium locus. The positive productivity shock improves the trade balance, which also requires a real appreciation to keep the trade account at a sustainable level.
Finally, government decisions on its consumption level and trade policy have effects on the ERER. An increase in government consumption of nontraded goods requires an increase in production in the nontraded goods sector; in turn, this requires an exchange rate appreciation. Conversely, if government consumption of traded goods increase, the trade balance deteriorates, and a depreciation is necessary to achieve external balance. Also, a reduction in an export subsidy has a similar effect on internal balance as a deterioration of terms of trade: IB shifts down as the increase in nontradables creates excess supply. External balance also shifts down, similar to a terms of trade change, but without the income effect. As a result, the exchange rate depreciates.
3. Empirics
a. Data
The quarterly data set spans two decades, starting in the first quarter of 1975 and ending in the second quarter of 1995 (Chart 8). All variables, except the interest rate, are in logarithms. For the real exchange rate, reer we use the CPI based real effective exchange rate, calculated by the IMF. 1/ An increase in the rate means an appreciation. The productivity variable, prod, is the difference in productivity in the manufacturing sector between Finland and its trading partners. 2/ For world interest rates, R, we use long-term real interest rate in Germany. The terms of trade, tt, are the price of exports relative to the price of imports.
FINLAND: DETERMINANTS OF REAL EXCHANGE RATES
Citation: IMF Staff Country Reports 1996, 095; 10.5089/9781451813128.002.A002
Sources: International Financial Statistics, Bank of Finland, Competitiveness Indicator System, and staff calculations.FINLAND: DETERMINANTS OF REAL EXCHANGE RATES
Citation: IMF Staff Country Reports 1996, 095; 10.5089/9781451813128.002.A002
Sources: International Financial Statistics, Bank of Finland, Competitiveness Indicator System, and staff calculations.FINLAND: DETERMINANTS OF REAL EXCHANGE RATES
Citation: IMF Staff Country Reports 1996, 095; 10.5089/9781451813128.002.A002
Sources: International Financial Statistics, Bank of Finland, Competitiveness Indicator System, and staff calculations.We also use additional variables that are not directly taken into account in the theory section. The structure of trade, and therefore the exchange rate permanently shifted as trade with the Former Soviet Union collapsed. We capture this effect with a dummy variable, Dum91, equal to unity starting in the first quarter of 1991. There are also large, one-time jumps in the real exchange rate due to devaluations. We single out these points by using a dummy variable, dumdev, that is unity during the devaluation periods.
We have not included government consumption and tariffs, quotas, and export subsidies in our dataset. Government consumption decomposed into tradable and nontradable goods is not available. A summary index of protection is not available in a usable form, either. Moreover, the degree of protection appears to have been relatively constant across our sample.
One last aspect, relating to the short-run real effects of nominal variable, needs to be discussed. In periods of fixed exchange rate, the observed real exchange rate may deviate from its long-run equilibrium not only because of adjustment lags, but also as a result of financial policies. For example, a monetary expansion that results in higher domestic inflation brings about a real appreciation if the nominal exchange rate is fixed. This appreciation moves the observed real exchange rate away from equilibrium. This deviation is not sustainable in the long run. However, in the short run, financial policies may explain even large swings in the observed real exchange rate. These swings can, in principle, be modelled as done in Edwards (1994). In practice, however, modelling these effects through some measure of financial policies is difficult: for example, using some measure of the money supply is not appropriate if there are relevant shifts in money demand. 1/ Thus, we tackle with this problem by including in our equations a variable that measures directly the effect of the stance of financial policies: the price differential between Finland and its trading partners, ppoth, which is nonzero before the exchange rate was floated. As an increase in ppoth signals a relaxation of monetary policy, under fixed exchange rate, we expect it to be positively correlated with the real exchange rate. Under the floating exchange rate, a different short term effect should be considered. An increase in domestic interest rates stimulates capital inflow, bringing with it an appreciated nominal exchange rate, and if prices do not adjust immediately, a temporary appreciation of the real exchange rate. To capture such short term effects, we use the deviations from uncovered interest parity uip, calculated by assuming perfect foresight, for the period when the exchange rate was floating.
We paid special attention to the stationarity properties of the variables. Since fundamentals are defined as variables that affect the real exchange rate in the long run, they should have the same order of integration as the real exchange rate. If the real exchange rate is stationary, in the sense that it reverts to a particular mean, then the fundamental should be stationary too. However, if the exchange rate is nonstationary, then any stationary variable cannot be a fundamental. This is because any variable that drifts stochastically permanently away from its mean cannot be affected in the long run by a variable that reverts to its mean; the effects remain only in the short run. Of course, nonstationary variables should be examined under the framework of cointegration.
The univariate statistical properties of the variables are summarized in Table 4. 2/ The real effective exchange rate appears to contain a unit root: neither the Augmented Dickey-Fuller (ADF) test nor the Phillips-Per on (PP) test rejects the null hypothesis of a unit root, and the estimated roots are very close to unity. 3/ This result is in line with other findings in the literature. 4/
Univariate Statistical Properties
Univariate Statistical Properties
| Variable | trend | lags | ADF | PP |
|---|---|---|---|---|
| reer | No | 3 | −2.3439 | −2.2360 |
| tt | No | 2 | −1.4071 | −1.6524 |
| r | No | 2 | −3.2017** | −2.6426* |
| prod | Yes | 2 | −3.7057** | −3.9291** |
| ppoth | No | 3 | −2.3912 | −3.7617*** |
| uip | No | 0 | −2.5852* | −2.5381 |
Univariate Statistical Properties
| Variable | trend | lags | ADF | PP |
|---|---|---|---|---|
| reer | No | 3 | −2.3439 | −2.2360 |
| tt | No | 2 | −1.4071 | −1.6524 |
| r | No | 2 | −3.2017** | −2.6426* |
| prod | Yes | 2 | −3.7057** | −3.9291** |
| ppoth | No | 3 | −2.3912 | −3.7617*** |
| uip | No | 0 | −2.5852* | −2.5381 |
The unit root test results are mixed and inconclusive for some of the variables. The existence of a unit root cannot be rejected in the case of the terms of trade. By contrast, the hypothesis of a unit root in the german long-term real interest rate can be rejected at 5 percent if ADF test is used, but cannot be rejected if FP test is used. For the productivity differential, the null hypothesis can be rejected at 5 percent, irrespective of the type of the test, in favor of stationarity around a deterministic trend. The existence of a trend could be at least partly explained by the high investment ratio in Finland relative to its trading partners. We should note that if we do not include a deterministic trend in modeling the productivity differential, ve do not reject the existence of a unit root. The price differential appears strongly stationary under the PP test, but nonstationary under the ADF test. Uip has the opposite characteristic.
Since the tests are not conclusive, we cannot rule out the possibility that the series are nonstationary. After all, the inference is biased toward too frequent rejections only if we mistakenly assume that a series is stationary. The cointegration technique discussed below also can shed some light into this issue: if a variable is stationary, then it should not significantly affect the cointegration relation and could be kept out. If we do not find a variable significant in the cointegrating vector, that becomes another indication that that variable is stationary.
b. Methodology
In this section, we discuss the empirical methodology used in investigating the relationship between the real exchange rate and its fundamentals. As discussed above, there is a strong indication that the CPI based real exchange rate in Finland does not tend to revert to any mean. Stochastic and deterministic trends are also found in the fundamentals. Such statistical properties of the data require us to use the cointegration technique, which is suitable for handling nonstationary data to search for a relationship between the variables of interest. 1/ Another characteristic of cointegration is that the relationship uncovered holds in the long nan, which is more appropriate for the fundamentals we are searching for.
We utilize the full information maximum likelihood system approach (Johansen (1988, 1989), and Johansen and Juselius (1990)). We define the long-run relationship between the real effective exchange rate and the fundamentals as follows:
where xt is the vector of the fundamentals, β is the vector of cointegrating coefficients, and zt is the error term. If the exchange rate and the variables that we consider to be fundamentals form an equilibrium, then they should not deviate from each other too much for too long. This means that the error zt, which can be interpreted as deviations from the equilibrium, should be stationary. The exchange rate that is predicted from this equation (et* =xt’β*, where β* is the estimated vector of coefficients) is the long-run equilibrium rate that is defined by the fundamentals at each time t.
We also define the short-run dynamics consistent with the long-run equilibrium. This is done by modeling the exchange rate as an error correction mechanism (ECM):
Here, the change in the exchange rate is affected by its past changes, and by changes in fundamentals and other short-run variables, wt. More important, it is affected by past deviations from the equilibrium. If, for instance, the exchange rate at t-1 was overvalued relative to the fundamentals, then zt-1 is positive. This period, the exchange rate corrects itself by an amount dictated by the coefficient α. Contemporaneous values of the fundamentals can be introduced on the right hand side if such variables are weakly exogenous, in the sense that in the long run they are not influenced by the equilibrium. The coefficients of the contemporaneous differenced variables can also be interpreted as short-run elasticities. Lagged differenced values of the exchange rate and the fundamentals are introduced to whiten the error.
The system full information maximum likelihood method is the most efficient among the alternatives, if the assumptions on the data generating processes of the random shocks to the system are valid (see Hamilton 1995). The errors should have normal distribution, should not be serially correlated, and should not have any conditional heteroscedasticity or nonlinearity. The diagnostic tests are performed by estimating an unrestricted VAR with sufficient lags to eliminate any remaining serial correlation, and then checking the properties of the residuals. The Jarque-Bera and the portmanteau tests are used to for normality and serial correlation. For nonlinearities, squared terms of the variables are tested for significance.
We test for the existence of a relationship between the set of fundamentals and the real effective exchange rate using the Johansen cointegration test. Once cointegration is established, we test for the significance of each variable in the cointegrating vector. Acceptance of insignificance of a variable may mean that that variable is not a fundamental. We also test for the weak exogeneity of the fundamentals. Economic theory suggests that we should take the exogeneity of the variables as the maintained hypothesis. Thus, testing for exogeneity can be seen as another means of model validation.
Next, we model the short-run adjustment by incorporating the cointegrating vector obtained from the Johansen procedure into the ECM. Here, we go from general to specific by starting with the longest lag length for all variables, and eliminating the insignificant ones.
c. Results
(1) Cointegration diagnostics and results
in the unrestricted VAR, we included three lags of the real exchange rate and its fundamentals (terms of trade, the German long-term real interest rate, and the productivity differential). We also included the shift dummy for the collapse of trade with the Soviet Union, the dummy that indicates the devaluation periods, and a trend term to explain the trend in the productivity differential variable.
We are interested in the outcome of the diagnostic tests on the residuals: if there are no indications against the validity of the assumptions for system estimation, we can use the Johansen procedure. The results of the diagnostic test are presented below in Table 5. None of the test statistics rejects the null hypothesis in question. Three lags seem to be sufficient to eliminate any serial correlation in the residuals. The assumptions of normality and conditional homoscedasticity are not rejected for any of the residuals. There are no signs of a nonlinear relationship in the system either.
Diagnostic Tests
Diagnostic Tests
| Test | Test Distribution | Test Statistic | |
|---|---|---|---|
| serial correlation | X2(9) | 16.89 | |
| reer equation | normality | X2(2) | 4.52 |
| ARCH | F(4,55) | 0.53 | |
| nonlinearity | F(27,35) | 1.75 | |
| The whole VAR system | serial correlation | X2(36) | 122.24 |
| normality | X2(8) | 8.72 | |
| nonlinearity | F(270,270) | 0.74 |
Diagnostic Tests
| Test | Test Distribution | Test Statistic | |
|---|---|---|---|
| serial correlation | X2(9) | 16.89 | |
| reer equation | normality | X2(2) | 4.52 |
| ARCH | F(4,55) | 0.53 | |
| nonlinearity | F(27,35) | 1.75 | |
| The whole VAR system | serial correlation | X2(36) | 122.24 |
| normality | X2(8) | 8.72 | |
| nonlinearity | F(270,270) | 0.74 |
The results of the cointegration tests are in Table 6. The trace statistics, adjusted for the degrees of freedom, point to a single cointegrating vector. 1/ The cointegrating vectors associated with each cointegration test are tabulated in Table 7.
Cointegration Tests
Cointegration Tests
| Eigenvalue statistics | Trace statistics | |||
|---|---|---|---|---|
| Ho: p = number of cointegrating vectors | Adjusted for d.f. | Unadjusted for d.f. | Adjusted for d.f. | Unadjusted for d.f. |
| p == 0 | 29.19 | 34.42** | 69.91*** | 82.43*** |
| p <= 1 | 21.62 | 25.49 | 40.72 | 48.02** |
| p <= 2 | 13.59 | 16.03 | 19.10 | 22.52 |
| p <= 3 | 5.51 | 6.50 | 5.51 | 6.50 |
Cointegration Tests
| Eigenvalue statistics | Trace statistics | |||
|---|---|---|---|---|
| Ho: p = number of cointegrating vectors | Adjusted for d.f. | Unadjusted for d.f. | Adjusted for d.f. | Unadjusted for d.f. |
| p == 0 | 29.19 | 34.42** | 69.91*** | 82.43*** |
| p <= 1 | 21.62 | 25.49 | 40.72 | 48.02** |
| p <= 2 | 13.59 | 16.03 | 19.10 | 22.52 |
| p <= 3 | 5.51 | 6.50 | 5.51 | 6.50 |
Cointegrating Vectors
Cointegrating Vectors
| reer | tt | r | prodf | dum91 | trend | |
|---|---|---|---|---|---|---|
| 1 | 1.00 | −0.90 | 0.09 | 3.75 | 0.18 | −0.03 |
| 2 | −10.21 | 1.00 | −4.10 | 26.64 | −11.93 | −0.01 |
| 3 | −29.10 | 21.51 | 1.00 | −6.63 | −1.48 | 0.02 |
| 4 | −0.07 | −0.92 | 0.03 | 1.00 | −0.08 | −0.00 |
Cointegrating Vectors
| reer | tt | r | prodf | dum91 | trend | |
|---|---|---|---|---|---|---|
| 1 | 1.00 | −0.90 | 0.09 | 3.75 | 0.18 | −0.03 |
| 2 | −10.21 | 1.00 | −4.10 | 26.64 | −11.93 | −0.01 |
| 3 | −29.10 | 21.51 | 1.00 | −6.63 | −1.48 | 0.02 |
| 4 | −0.07 | −0.92 | 0.03 | 1.00 | −0.08 | −0.00 |
Next, we run a set of exclusion and exogeneity tests on the system, with results given in Table 8. 1/ The exclusion restrictions are all rejected, lending support to the hypothesis that the real exchange rate and the vector of fundamentals are of the same order of integration. More important, these results imply that the terms of trade, real interest rate, and productivity affect the exchange rate in the long run.
Exclusion and Exogeneity Tests
Exclusion and Exogeneity Tests
| Test | Variable | X2 statistic |
|---|---|---|
| Exclusion from the fundamentals | tt | 2.6642* |
| r | 3.6622* | |
| prod and trend | 11.9928*** | |
| tt | 0.1481 | |
| Weak exogeneity | r | 0.0255 |
| prod and trend | 8.6682*** |
Exclusion and Exogeneity Tests
| Test | Variable | X2 statistic |
|---|---|---|
| Exclusion from the fundamentals | tt | 2.6642* |
| r | 3.6622* | |
| prod and trend | 11.9928*** | |
| tt | 0.1481 | |
| Weak exogeneity | r | 0.0255 |
| prod and trend | 8.6682*** |
The tests also show that the terms of trade and the real interest rate are exogenous to the system, as expected. However, weak exogeneity in the case of the productivity differential is rejected. 2/ It is conceivable that productivity can deviate from its trend due to some common factors that affect the exchange rate. Nevertheless, this effect can only be in the short run and cannot justify a feedback to productivity in the long run.
Given our priors, ve model all the fundamentals as exogenous, and estimate the cointegration relation with this maintained assumption. The resulting vector is as follows:
The coefficients are of the expected sign: the real exchange rate appreciates in the long run if the terms of trade improve, or the interest rate goes up, or the productivity differential increases above the trend.
We also model the short-run adjustment through the ECM. We take the implied error correction vector, Zt-1 from the Johansen procedure and use it in the ECM, together with current and past differenced fundamentals and other variables that affect the real exchange rate in the short run. We eliminate all variables that are not significant. The results are as follows: 1/
All the coefficients are highly significant. The price differential has the expected sign: a higher price level in Finland leads to an appreciated real exchange rate in the short run, during the managed exchange rate period. Similarly, a positive deviation from the uncovered interest parity leads to an appreciated exchange rate during floating exchange rate period. As model validation, we see that both lagged dependent variables are significant, justifying the use of three lags in levels, and the adjustment coefficient is almost identical to the one estimated in the Johansen method.
(2) Implications
The fundamentals imply a long-run equilibrium exchange rate at each point in time that is calculated from the cointegrating vector we estimated above (Chart 9). The movements of these estimated equilibrium rates can be explained by combining the individual effects of each of the fundamentals.
FINLAND: REAL EFFECTIVE EXCHANGE RATES, 1975–2000
(In logs)
Citation: IMF Staff Country Reports 1996, 095; 10.5089/9781451813128.002.A002
Sources: PDR, Information Notice System, and staff calculations.FINLAND: REAL EFFECTIVE EXCHANGE RATES, 1975–2000
(In logs)
Citation: IMF Staff Country Reports 1996, 095; 10.5089/9781451813128.002.A002
Sources: PDR, Information Notice System, and staff calculations.FINLAND: REAL EFFECTIVE EXCHANGE RATES, 1975–2000
(In logs)
Citation: IMF Staff Country Reports 1996, 095; 10.5089/9781451813128.002.A002
Sources: PDR, Information Notice System, and staff calculations.At the beginning of our sample, in 1975, there was a sharp decline in the equilibrium exchange rate as the terms of trade and the productivity differential fell. Since then, the equilibrium exchange rate seems to have been quite stable until the mid-1980s. During this period, the impact of a decline in the terms of trade was rougly offset by the effects of an increase in the world real interest rate and more rapid productivity growth.
In the past decade, the equilibrium exchange rate seems to have had two major shifts. In 1986, the equilibrium rate appreciated sharply, owing to a strong improvement in the terms of trade. The effect of further improvement in the terms of trade in late 1980’s was offset by that of a sharp decline in interest rates. This appreciated level of equilibrium was maintained until the beginning of 1990’s when the declines in the world interest rates and relative productivity and a deterioration of the terms of trade caused the equilibrium rate to depreciate dramatically below the early 1980’ s level. This depreciation was also influenced by the collapse of trade with the Former Soviet Union. More recently, the recovery of the terms of trade and the interest rate, combined with a sharp increase in the relative productivity, has pushed up the equilibrium rate. However, since the structure of trade with the Former Soviet Union countries has changed, the previous equilibrium level has not been attained.
We also made projections for the equilibrium exchange rate into the near future. In our projection, we assume that productivity will continue to rise along its trend, world real interest rates will not change, and that the terms of trade will fall by 1.5 percent and 3.9 percent in 1996 and 1997 (see SM/96/159). Incorporating these assumptions into the estimated model leads to projections of the equilibrium real exchange rate that remain roughly unchanged in the next few years.
The actual exchange rate has deviated from the estimated long-run equilibrium exchange rate at times with long durations (Chart 10). As the equilibrium rate appreciated in 1986, the actual exchange rate remained undervalued for approximately three years, until 1989. When the equilibrium rate depreciated at the end of 1990, the actual exchange rate remained overvalued for two years before the markka was floated and the actual rate surpassed the equilibrium rate. 1/ Since then, the markka stayed undervalued until 1995, when the markka seems to have converged back to a level that is broadly in line with the fundamentals.
FINLAND: REAL EFFECTIVE EXCHANGE RATE MISALIGNMENTS, 1975–1995
(In logs)
Citation: IMF Staff Country Reports 1996, 095; 10.5089/9781451813128.002.A002
Source: Staff calculations.FINLAND: REAL EFFECTIVE EXCHANGE RATE MISALIGNMENTS, 1975–1995
(In logs)
Citation: IMF Staff Country Reports 1996, 095; 10.5089/9781451813128.002.A002
Source: Staff calculations.FINLAND: REAL EFFECTIVE EXCHANGE RATE MISALIGNMENTS, 1975–1995
(In logs)
Citation: IMF Staff Country Reports 1996, 095; 10.5089/9781451813128.002.A002
Source: Staff calculations.The ECM can shed some light to the nature of these large deviations. The adjustment coefficient that captures how much a deviation from equilibrium influences the exchange rate is small: it takes approximately one and a half years for half of the adjustment to take place. Also, none of the contemporenous differenced fundamentals are significant, implying that the short-run influence of the fundamentals is minimal.
The variables that primarily explain the short-run deviations are the price differential between Finland and its trading partners, and deviations from uncovered interest parity. An increase in domestic prices relative to the prices of Finland’s trading partners is not immediately reflected in the nominal exchange rate during the managed exchange rate era, and this leads to periods of overvaluation. Similarly, there are important deviations from uncovered interest parity. As expected, an increase in the domestic interest rate (without a corresponding increase in the world interest rate) lowers consumption and leads to capital inflows, appreciating the real exchange rate during the floating exchange rate period.
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Prepared by Tarhan Feyzioglu.
The recent advances can be found in Williamson (1994). This approach is used for Finland by Hoj (1995) and Saarenheimo (1995).
If the outcome is unsustainable, the target current account would be that implied by the smallest fiscal adjustment that secures sustainability. If the current account targets of the trading partners are collectively inconsistent, then the largest target surpluses would be reduced until inconsistency is eliminated.
As is seen the results, the fact that markka has been floating in the last three years does not affect the long-run relationship we are seeking.
The assumption of balanced budget results in households doing all the borrowing in the economy. The reduced form we examine 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 approach, see Obsfeld and Rogoff (1995).
Thus, an increase in e involves a real appreciation.
We use this definition (external exchange rate) rather than the internal real exchange rate used in the theoretical part because we lack good measurement of the former. As long as the law of one price holds for the traded goods, it can be shown that the external rate is equal to the internal rate, scaled by the internal rate of the rest of the world (see Hinkle and Nsengiyumva (1996)). We assume that the variation in the aggregate internal exchange rate of Finland’s trading partners is not large enough to reverse the relationship between the external exchange rate and the fundamentals. For simplicity we also concentrate on the CPI based real exchange rate rather than the unit labor cost based measure. For a detailed analysis of the difference between these definitions, see Lipschitz and McDonald (1992).
The theory section emphasized the productivity difference between the tradable and nontradable sectors, but such data are not readily available. The expected influence on the exchange rate of the productivity measure we use, given our definition of the real exchange rate is the same as in the theoretical model.
Indeed, money demand in Finland is regarded as quite unstable.
In all the tables in this chapter, 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 we consider a break in 1991, and repeat the tests by splitting the sample.
For example, see Juselius (1995). For an exception, see Lothian and Taylor (1996), where they find mean reversion in the Dollar/Sterling and Franc/Sterling real exchange rate that spans almost two centuries.
Edwards (1994) uses least squares method in searching for the fundamentals. Elbadawi (1994) and Faruqee (1995) use the cointegration method, but within different theoretical frameworks.
We produce the unadjusted figures to get a sense of the lack of power due to a small sample. Unadjusted for the degrees of freedom, both the trace statistic and the eigenvalue statistics indicate the existence of a cointegrating vector, and trace statistics hint for a second cointegrating vector. There may be a second cointegrating vector, especially if we believe that the productivity differential is stationary, since it dominates the second cointegrating vector with its large coefficient.
All tests have x2 distributions with 1 degree of freedom, except the tests on prod and trend where there are 2 degrees of freedom.
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.
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 before. Since we do not use a smooth dummy, we may be overestimating the equilibrium exchange rate just before 1991.
