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Examining finite-sample problems in the application of cointegration tests for long-run bilateral exchange rates

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    Abstract

    Numerous empirical studies investigate whether exchange rates are related to `economic fundamentals' in the long-run and find a range of relationships through cointegration analysis. We report similar cointegrating relationships for the value of the New Zealand dollar relative to the US dollar (NZD/USD) and for the value of the New Zealand dollar relative to the Australian dollar (NZD/AUD). These include determinants such as commodity prices, 90-day interest rate differentials, and inflation and growth differentials. However, Godbout and van Norden (1997) demonstrate that finite-sample problems may have affected the conclusions of such cointegration studies. Through a simple Monte Carlo study, we consider whether the cointegration coefficients can reasonably be interpreted as `long-run' elasticities of the exchange rate to changes in fundamental variables. The simulation results suggest that given a relatively short span of data it is possible for cointegration analysis to indicate that a long-run relationship has been found when in fact there is only a cyclical relationship. Therefore caution is advised when interpreting the empirical results and making policy assessments about the nature of exchange movements relative to its broad trend.

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    File URL: http://www.rbnz.govt.nz/research_and_publications/discussion_papers/2004/dp04_08.pdf
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    Paper provided by Reserve Bank of New Zealand in its series Reserve Bank of New Zealand Discussion Paper Series with number DP 2004/08.

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    Length: 36 p.
    Date of creation: Oct 2004
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    Handle: RePEc:nzb:nzbdps:2004/08

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    1. James G. MacKinnon, 1995. "Numerical Distribution Functions for Unit Root and Cointegration Tests," Working Papers, Queen's University, Department of Economics 918, Queen's University, Department of Economics.
    2. Marie-Josée Godbout & Simon van Norden, 1997. "Reconsidering Cointegration in International Finance: Three Case Studies of Size Distortion in Finite Samples," Working Papers, Bank of Canada 97-1, Bank of Canada.
    3. Gonzalo, Jesus & Lee, Tae-Hwy, 1998. "Pitfalls in testing for long run relationships," Journal of Econometrics, Elsevier, Elsevier, vol. 86(1), pages 129-154, June.
    4. DeJong, David N, et al, 1992. "Integration versus Trend Stationarity in Time Series," Econometrica, Econometric Society, Econometric Society, vol. 60(2), pages 423-33, March.
    5. Niels Haldrup & Michael Jansson, 1999. "Spurious Regression, Cointegration, and Near Cointegration: A Unifying Approach," Tinbergen Institute Discussion Papers, Tinbergen Institute 99-005/4, Tinbergen Institute.
    6. Maddala,G. S. & Kim,In-Moo, 1999. "Unit Roots, Cointegration, and Structural Change," Cambridge Books, Cambridge University Press, Cambridge University Press, number 9780521587822.
    7. Cheung, Yin-Wong & Chinn, Menzie David, 2001. "Currency traders and exchange rate dynamics: a survey of the US market," Journal of International Money and Finance, Elsevier, Elsevier, vol. 20(4), pages 439-471, August.
    8. Graham Elliott, 1998. "On the Robustness of Cointegration Methods when Regressors Almost Have Unit Roots," Econometrica, Econometric Society, Econometric Society, vol. 66(1), pages 149-158, January.
    9. Ronald MacDonald, 2002. "Modelling the Long-run Real Effective Exchange Rate of the New Zealand Dollar," Australian Economic Papers, Wiley Blackwell, Wiley Blackwell, vol. 41(4), pages 519-537, December.
    10. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 1(1), pages 19-46, January.
    11. Anella Munro, 2004. "What drives the New Zealand dollar?," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, Reserve Bank of New Zealand, vol. 67, june.
    12. James H. Stock & Mark W. Watson, 1991. "A simple estimator of cointegrating vectors in higher order integrated systems," Working Paper Series, Macroeconomic Issues, Federal Reserve Bank of Chicago 91-3, Federal Reserve Bank of Chicago.
    13. Chen, Yu-chin & Rogoff, Kenneth, 2003. "Commodity currencies," Journal of International Economics, Elsevier, Elsevier, vol. 60(1), pages 133-160, May.
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    Cited by:
    1. Anella Munro, 2005. "UIP, Expectations and the Kiwi," Reserve Bank of New Zealand Discussion Paper Series, Reserve Bank of New Zealand DP2005/05, Reserve Bank of New Zealand.

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