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Behavioural equilibrium exchange rate and total misalignment: evidence from the euro exchange rate

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Abstract

In the present paper we attempt to investigate whether the nominal exchange rate of the euro against the currencies of the four major trading partners of the eurozone, namely China, Japan, the UK and the USA, converges or not to its equilibrium level. Applying recent unit root and system cointegration techniques in the presence of structural shifts in the data, our results indicate that there exist an equilibrium relationship between each of the euro/yuan, euro/yen, euro/UK pound and euro/US dollar nominal exchange rates and the fundamentals defined by the monetary model. Following these results, our modified Behavioural Equilibrium Exchange Rate model suggests that at the end of the estimated period, the euro/Chinese yuan and the euro/UK pound nominal exchange rates follow an equilibrium process. Our empirical results also imply that the single European currency is considered as overvalued against the US dollar, while it is considered as undervalued against the Japanese currency.

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Notes

  1. See Egert (2004) for an analytical presentation of these models.

  2. The use of non-monetary variables, such as the terms of trade, current account, net foreign asset position, debt ratio and others is more appropriate for the estimation of the real effective exchange rates. Since we investigate nominal exchange rates, the fundamentals of the monetary model are suitable for estimating a bilateral nominal exchange rate.

  3. For more details about the monetary model, see MacDonald and Taylor (1991, 1992), MacDonald (1995) and Groen (2000).

  4. S is the nominal exchange rate and m, y, r represent the domestic real money supply, real income and interest rate, respectively, while the asterisk denotes the respective foreign variables.

  5. Although vector Z 2 is considered as empty, it is presented for exponential purposes.

  6. Although the sample period is relatively small, it is suitable for our analysis. Our study does not imply the detection of a steady-state rate around which the exchange rate should move for the next decades. Actually, our equilibrium analysis aims to find, based on the information from the last 10 years, whether the euro exchange rate is consistent with the macroeconomic fundamentals and to discuss the macroeconomic aftermath of a possible misalignment. We believe that 10 years of data are enough to conduct this kind of equilibrium analysis.

  7. For instance, Denmark and the UK that were participating in the ECU did not adopt the euro. In contrast, Austria and Finland that adopted the euro in 1999 were not participating in the ECU.

  8. The Gauss codes of J. Lee are available at the website http://www.cba.ua.edu/~jlee/gauss.

  9. For these estimations we used the JMulti software, available at the website http://www.jmulti.de.

  10. Seasonally adjusted data for money supply and industrial production were obtained from the central bank and the official statistical service of each sample country, respectively.

  11. The industrial production (IP) differential and the intercept are not reported in (19) because were found to be statistically insignificant. Moreover, SB1 stands for the first structural break in October 2004, while SB2 stands for the second break in April 2006.

  12. For a comprehensive survey of recent estimates of the equilibrium effective and bilateral exchange rate of the Chinese currency vis-à-vis the US dollar, see Cline and Williamson (2007).

  13. China runs a growing trade surplus with the European countries and the US, but it runs increasing deficits with developing and emerging Asian economies.

  14. Of course, and especially for the period until 2005 when the Chinese currency was completely pegged to the US dollar, the dynamic behaviour of the euro/yuan exchange rate is partly explained by the movements of the euro/US dollar exchange rate, which is analysed below. It is indicative that both exchange rates and the corresponding equilibrium rates follow the same downward pathway (see, Figs. 1 and 4). Moreover, during this period, both estimated equilibrium rates imply identical misalignment status for the euro (i.e. overvaluation).

  15. The intercept, the money supply differential and the first structural break (SB1) in July 2000, are not reported in (20) because were found to be statistically insignificant. The second structural break (SB2), which is statistically significant, is located in April 2001.

  16. Similarly to the euro/yuan case, the euro/yen exchange rate is partly explained by the movements of the euro/US dollar exchange rate, because the Japanese currency is oriented more to the US dollar than the euro.

  17. Rosenberg (2003) states that the Japanese yen is expected to depreciate because the internal imbalance will offset any positive developments on the external balance.

  18. The effects of stock market developments on economic growth are, among others, analysed by Arestis and Demetriades (1997), De Avila (2003), Gardener et al. (2001), Levine and Zervos (1998).

  19. The intercept, the inflation rate differential and the second structural break (SB2) in August 2006, are not reported in (21) because were found to be statistically insignificant. The first structural break (SB1), which is statistically significant, is located in December 2002.

  20. The two structural breaks (March 2003 and March 2005), along with the constant term and the IP differential, are not reported in (22) because were found to be statistically insignificant.

  21. As we already explained, the BEER is a function of the equilibrium values of the fundamentals. Namely, temporary shocks as well as the macroeconomic policy with only temporary effects on the economy can explain why exchange rates deviate from their equilibrium values in the long-run.

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Acknowledgments

The authors are grateful to Carsten Trenkler for kindly providing them with the Gauss codes for the cointegration estimations with structural breaks, in Sect. 4.2. They also like to thank two anonymous referees for their constructive suggestions and helpful comments, which improved the quality and the exposition of the paper. Of course, the usual caveat applies.

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  1. Department of Economics, University of Ioannina, Ioannina, Greece

    Nikolaos Giannellis

  2. Department of Economics, University of Crete, Crete, Greece

    Minoas Koukouritakis

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  1. Nikolaos Giannellis
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  2. Minoas Koukouritakis
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Correspondence to Minoas Koukouritakis.

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Giannellis, N., Koukouritakis, M. Behavioural equilibrium exchange rate and total misalignment: evidence from the euro exchange rate. Empirica 38, 555–578 (2011). https://doi.org/10.1007/s10663-010-9146-z

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