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

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
Date of revision:
Handle: RePEc:nzb:nzbdps:2004/08
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  1. Ronald MacDonald, 2001. "Modelling the long-run real effective exchange rate of the New Zealand Dollar," Reserve Bank of New Zealand Discussion Paper Series DP2002/02, Reserve Bank of New Zealand.
  2. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January.
  3. Yin-Wong Cheung & Menzie D. Chinn, 2000. "Currency Traders and Exchange Rate Dynamics: A Survey of the U.S. Market," CESifo Working Paper Series 251, CESifo Group Munich.
  4. DeJong, David N, et al, 1992. "Integration versus Trend Stationarity in Time Series," Econometrica, Econometric Society, vol. 60(2), pages 423-33, March.
  5. James H. Stock & Mark W. Watson, 1991. "A simple estimator of cointegrating vectors in higher order integrated systems," Working Paper Series, Macroeconomic Issues 91-3, Federal Reserve Bank of Chicago.
  6. Gonzalo, Jesus & Lee, Tae-Hwy, 1998. "Pitfalls in testing for long run relationships," Journal of Econometrics, Elsevier, vol. 86(1), pages 129-154, June.
  7. Maddala,G. S. & Kim,In-Moo, 1999. "Unit Roots, Cointegration, and Structural Change," Cambridge Books, Cambridge University Press, number 9780521587822.
  8. Graham Elliott, 1998. "On the Robustness of Cointegration Methods when Regressors Almost Have Unit Roots," Econometrica, Econometric Society, vol. 66(1), pages 149-158, January.
  9. Anella Munro, 2004. "What drives the New Zealand dollar?," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 67, june.
  10. James G. MacKinnon, 1995. "Numerical Distribution Functions for Unit Root and Cointegration Tests," Working Papers 918, Queen's University, Department of Economics.
  11. Chen, Yu-chin & Rogoff, Kenneth, 2003. "Commodity currencies," Journal of International Economics, Elsevier, vol. 60(1), pages 133-160, May.
  12. Marie-Josée Godbout & Simon van Norden, 1997. "Reconsidering Cointegration in International Finance: Three Case Studies of Size Distortion in Finite Samples," Working Papers 97-1, Bank of Canada.
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