Applied Econometrics: Do relative prices determine the Malaysian exchange rate?

Introduction to theme

One of the most fundamental ways of modelling exchange rates is to specify relative prices as the main determinant. Broadly speaking Purchasing Power Parity (PPP) suggests that the exchange rate between two countries is equal to the ratio of their general price levels. This is a core principle of international economic and finance theory and is assumed to hold in, for example, monetary models of exchange rate determination.[1] However, the empirical evidence generally rejects PPP in the short-run while the evidence for PPP holding in the longrun is mixed (Bahmani-Oskooee and Hegerty, 2009). The “PPP puzzle” is that theory suggests that PPP should clearly hold, however, the empirical evidence is less than clear, with many researchers finding evidence that rejects it. This puzzle remains an unresolved issue in the economics literature and continues to warrant investigation. As such, testing for PPP is a relevant theme to be considered by undergraduate economics students in their capstone module.

A range of potential explanations for the many empirical rejections of PPP have been offered.

Some examples include the use of incorrect data in the tests, productivity differentials (the Balassa-Samuelson effect), corruption, natural resource endowments and the inadequacy of the econometric techniques used (Bahmani-Oskooee and Hegerty, 2009). Regarding the latter, time-series econometrics has developed over the past 50 years to account for the typical nonstationarity of macroeconomic data – that is, many macroeconomic data (including the price data used in testing PPP) are trended (integrated). These dynamic econometric methods (sometimes referred to as modern econometrics) focus on testing for integration and cointegration.[2] Essentially, these methods test whether the trends in different data sets are forced together (are cointegrated) or drift apart over the long-run. If macroeconomic variables move together, rather than drift apart, fundamental economic forces (as postulated by economic theory) are attributed as the cause. Hence, integration and cointegration tests can be used to assess whether the exchange rate moves towards the relative prices of the associated countries in the long-run. As such, these dynamic econometric methods have been predominantly used to test whether PPP holds in the long-run. One avenue of research has been whether the rejections of PPP using integration and cointegration methods have been due to deficiencies in the tests used. As such integration and cointegration methods have been refined and developed to account for such deficiencies, such as non-linearities and structural breaks.

 

An introduction to dynamic econometrics by testing the PPP theory will provide students taking this theme with an insight into some of the fundamental modern econometric methods (and how to apply them) that should be part of any econometrician’s toolkit. As such, all student will learn the core of the theme, being: the PPP economic theory, data collection and analysis as well as dynamic econometric methods and their application. However, each student will (as a sub-theme) apply these methods to a different pair of countries. Given that different countries’ data will have different features that will likely raise different issues, each student’s analysis be distinct. The sub-themes are distinguished by the countries used, as indicated below.

Indicative reading

Econometrics textbooks

  • Asteriou, D., and Hall S. G. (2016) Applied Econometrics. 3rd Palgrave Macmillan.
  • Brooks, C. (2019) Introductory Econometrics for Finance. 4th CUP.

– see chapter 15 of Brooks (2019) for a guide on doing an empirical dissertation.

  • Gujarati, D. N., and Porter, D. C. (2009) Basic Econometrics. 5th McGraw Hill.
  • Verbeek, M. (2012) A Guide to Modern Econometrics. 4th Wiley.
  • Wooldridge, J (2020). Introductory Econometrics: A Modern Approach, Wiley (5th edition) – see chapter 19 of Wooldridge (2020) for a guide on doing an empirical dissertation.

As data are most readily available for the USA, it is mandatory that this is the base country. The other country in the analysis is Malaysia.

Student’s essay title will be:

Do relative prices determine the MALAYSIAN exchange rate?

A basic structure of the empirical 5000-word essay for the applied econometrics theme should be:

  • Abstract

A short (no more than a maximum of 200 word) summary of what you have done and what your findings are.

  • Introduction

State what you will do and why is it interesting – what question do you answer? Motivate your work. What is novel about your work (new country and/or more recent data)?

  • Literature review

Theoretical review (~1500 words) and empirical literature review (including recent literature from the last 10 or so years) (~1500 words).  (~3000 words in total)

  • This should not only describe previous research (the discussion should include commentary on the data, methods, findings etc) it should be critical.
  • There should also be a summary of the literature’s findings to motivate the work proposed in the essay.
  • Methodology

Discuss the theoretical models and/or econometric methods. Only use the Augmented Dickey-Fuller (ADF) test AND Cointegration (Engle – Granger) test.

 

  • Empirical results
  • Discuss your data, its features and how it corresponds to any noteworthy and/or relevant events of the country being studied.
  • Presenting, interpreting and discussing the application of methods and/or models to your
  • Conclusion

Summarize what you have done and state the conclusions of your work, possibly comparing and contrasting this with the previous literature.

  • Also make suggestions for future work perhaps motivated by any critical reflections of your own work.
  • Bibliography

Provide a full list of references of at least 15 papers cited in the text of your dissertation. Follow the Harvard referencing style.

[1] For example, the flexible-price version of the monetary model of exchange rate determination assumes that PPP holds continuously (in the short-run and the long-run) whereas the sticky-price version of the monetary model of exchange rate determination only assumes that PPP holds in the long-run (and not the short-run). See, for example, MacDonald, R. and Taylor, M. P. (1992) “Exchange Rate Economics A Survey” IMF Staff Papers, 39(1), pp. 1 – 57.

[2] Clive Granger and Robert Engle won the Nobel prize in 2003 for their work on cointegration. See, Engle, R. F. and Granger, C. W. J. (1987) “Cointegration and error correction: representation, estimation and testing” Econometrica, 55, pp. 251 – 276.