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MEAN REVERSION IN LONG-HORIZON REAL EXCHANGE RATES:

EVIDENCE FROM LATIN AMERICA  by Pablo Astorga

Institut Barcelona de Estudis Internacionals (IBEI), Spain 

Student:

Cristina Serac

Course name:

Development Macroeconomics

Lecturer:

 António Portugal Duarte

2012-2013 

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CONCEPTS

   What is it “mean reversion” ?Mean reversion is the theory that interest rates, security prices, or various economic indicators will, over time, returnto their long-term averages after a significant short-termmove.

  Half-life = measure of the speed of mean reversion andrefers to the number of years that it takes for deviations fromequilibrium to subside permanently below 0.5 in response toa unit shock in the level of the series.

  The real exchange-rate puzzles is a common term fortwo much-discussed anomalies of real exchange rates: thatreal exchange rates are more volatile and show more persistence than what most models can account for. 2

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In the past, Rogoff’s puzzle illustrated mean reversion in long-term horizon with a half-life average of 3-5 years .

  The new research approach reduces the mean reversion’s half -life average at 1,5 years.

How it is analysed the current study?

 Are chosen the economies of Latin America countries (LA6): Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela Period studied: XXth century  Steps:

1. Use a unit-root approach (structural breaks and trend behaviour) gives the possibility to compare the results

 with other studies that examine the PPP hypothesis withlong-span data.2. Use of an error correction model that consists ECM

framework fundamental variables (including relativeproductivities, terms of trade, trade openness, and realgovernment spending ) with the potential to shape the

equilibrium RER in theLA6 

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INTRODUCTION

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  Why this peripheric countries?

data availability 

They represent 80% of Latin America’s GDP and population 

Distinct features

They have met failure and succes in their development

Subordinate position in the world economic system

The earlier studies were focused on this type of countries just a little, especially long-term studies

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INTRODUCTION

 In processes with changing mean, the reversionappears faster than in processes with fixed mean.

Large deviations are fixed quicker than the smallones 

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INDICES

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C 

C 

 P 

 P  E  RER

*

E - nominal exchange rate

- consumer price index at home

- consumer price index in the comparator country C 

 P 

*

C  P 

Real Exchange Rate (Symmetric definition): 

k 

i

it it  jt  RERw REER1

Multilateral Real Exchange Rate:

 jt  REER - Index of multilateral or effectivereal rate for country j in period t

it w -Weight corresponding to trade

partner i in period t 

it  RER - Bilateral real exchange rate betweencountry j and country i

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At different times, the LA6 countries adopted variousexchange rate regimes:

under some sort of pegged regime (fixed, multiple or dualregimes) for more than 70% of the time in the last century 

the selection of the apppropriate rate hasfewer complications

Floating arrangements – with convertible currencies – were

rarely implemented, featuring mostly in the 1990s with theadoption of inflation targeting.

the appropriate rates selection refers tothose rates applied to import transactions

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INDICES

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RER 

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INDICES

Real depreciation of domestic currency 

RER  Real apreciation of domestic currency 

Internal price dynamics:

1920-1930s: Argentina and Mexico deflation till Great1900-1930s: Brazil and Columbia Depression

1970-1980s: Argentina, Brazil and Chile -> hyperinflation Venezuela and Mexico -> prices, exchange

rate stability 

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UNIT-ROOT APPROACH

  Structural breaks: Z&A methodology Min (test value) < critic level non-stationarity feature of the

series is determined by a structural break 

Z&A test to REER series null hypothesis of unit-root isrejected at 10% . Except for Chile: in this case, the test issignificant for year 1945.

  Testing for non-stationarity – making allowances for a one-time change in the trend function:

change in level for non-trending series additive outlier model Change in level for trending series Change in slope innovational outlier Change in level and slope model 8

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UNIT-ROOT APPROACH

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ROLE OF FUNDAMENTALS

  Terms of trade, trade policy, government implications – Edward’s Dynamic Model 

Economy goods:

exportable goods produced by country 

non-tradable goods

importable goods consumed by country 

Government - consumes importable goods and non-tradableones

- uses non-distortionary taxes and domestic creditto finance its expenditures

Long-run sustainable equilibrium export + non-tradablegoods market are in equilibrium

import tariffs

government consumption of non-tradable goods RER 

terms of trade appreciation

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  relative productivity  tradable sector RER 

appreciation

 World price level exchange rate

  ERROR CORRECTION MODEL (ECM)

Co-integration relationship

* - Equilibrium value

- fundamentals

k – vector of long-run multipliers

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ROLE OF FUNDAMENTALS

t  xk  REER *

t  x

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2 conditions to fulfill:

Series are co-integrated

Fundamentals are weakly exogenous for k 

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ROLE OF FUNDAMENTALS

use of single equation framework  variables treated in an endogenous way  

model estimated withoutimposing a long-term relationship 

  The last step – regression outcome – regressions are runfor each country over the whole sample in order to determinethe explanatory power of the fundamentals and estimate theerror-correction term – and its corresponding half-life value.

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CONCLUSIONS

the analyse found a very slow process of mean reversion– if any strict PPP hypothesis is rejected

The study half-life estimates are within the range of those reported in the long-span studies (after correcting

 by breaks) focusing on developed countries. The averagehalf-lives for the LA6 ranges from 1½ years when theunit-root approach is used to a conservative estimate of 2½ years under the ECM model. Better results thanthe 3-5 years range of Rogoff puzzle

Related to development and economic convergence, thisstudy indicates a depreciating trend over the last century.

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