Asia-Pacic Financial Markets 7: 155177, 2000. 2000 Kluwer Academic Publishers. Printed in the Netherlands.

155

Testing PPP Hypotheses between Japan and the Six G7 Countries

YOSHIHIKO TSUKUDA 1 and TATSUYOSHI MIYAKOSHI 2
1 Faculty of Economics, Tohoku University, Sendai 980-8576 Japan,

e-mail: tsukuda@econ.tohoku.ac.jp
2 Faculty of Economics, Niigata University, Niigata 950-2181 Japan,

e-mail: miyakosi@econ.niigata-u.ac.jp Abstract. The paper examines the purchasing power parity (PPP) theory of the foreign exchange rate of the yen against the currencies of the six G7 countries. We use the error-corrected ve-dimensional vector autoregressive (VAR) model with structural changes in the trend function. The data cover the period of the post-BretonWoods oating exchange rate system. The results reveal that the PPP relation alone determines the exchange rates for the USA, France, Germany, and Italy, while a linear combination of PPP and uncovered interest rate parity (UIP) relations determines that for Canada. In a model without trend breaks, the PPP relations hold only for Germany, which indicates that a correct specication of the sampling distribution of data is important. The one-step prediction based on the error correction model (ECM) outperforms the random walk model. The ECM is useful to predict the out-of-sample behaviors of the exchange rates. Key words: cointegration, error correction model, one-step prediction, purchasing power parity, uncovered interest rate parity.

1. Introduction The purpose of the paper is to empirically re-examine the hypotheses of purchasing power parity (PPP) relations between Japan as the home country and the USA, Canada, France, Germany, Italy, and the United Kingdom as the foreign countries. We employ a framework of the multivariate time series model by using the cointegration approach developed by Jonhansen and Juselius (1992). The PPP theory states that the long-run equilibrium exchange rate between two countries currencies is equal to the ratio of their price levels. Many practitioners in the business world believe that the PPP relation should hold in the long run. When the theory is applied to the real world, however, the relation between exchange rates and national price levels can be affected by many other factors such as the existence of nontraded goods, transport costs, trade restrictions, imperfect competitions, and measurement errors. A common feature of most of the empirical results seems to have been the apparent rejection of PPP during the period of oating exchange
An earlier version of this paper was presented at the annual meeting of the Japan Economic Association in 1997.

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rates. Roll (1979), Frenkel (1981), Cobae and Quliaris (1988), and Mark (1990) obtained negative evidence against the PPP. Cheung and Lai (1993) recently addressed the issue of measurement error in testing PPP and obtained the validity of the PPP in the context of the cointegrated vector autoregressive model (VAR) developed by Johansen (1991). They considered ve bilateral intercountry relations between the USA as the home country and the United Kingdom, France, Germany, Switzerland, and Canada as the foreign countries. Tsurumi (1994) obtained a similar result for the PPP between Japan and the USA. However, Cheung and Lai (1993) and Tsurumi (1994) did not account for the possible interaction between prices and interest rates. The uncovered interest rate parity (UIP) theory states that the transaction of assets between two countries will lead the interest rate of each country to the same level, if there is no risk on the assets. There are many papers on the interest rate parity; see Cumby and Mishkin (1986), Glick and Hutchison (1990), and Chinn and Frankel (1994) among others. However, most of previous studies investigated the covered or uncovered interest rate parity independently from the PPP relation. Johansen and Juselius (1992) attributed the rejection of the PPP to the lack of precise specication of the sampling distribution of the data: the general neglect of (i) time series properties of the data, (ii) possible interactions in the determination of prices, interest rates, and exchange rates, and (iii) differences between short-run and long-run effects. They provided a method of jointly analyzing the PPP and UIP in a full system of the VAR model. The above three factors can be simultaneously incorporated into the error correction model (ECM) of the VAR model. Similar analyses have been made on Australian data by Johansen (1992), Swedish data by Sjoo (1995), and Danish data by Juselius (1995). This paper examines the hypotheses of the PPP and UIP relations between the Japanese yen and the remaining six G7 currencies based on the ECM representation of the ve-dimensional VAR model. The data covers the period of the post-Breton Woods oating exchange rate system. We incorporate structural changes in the trend function in the years 1980 and 1985. The trend breaks are introduced to account for the institutional aspects of the capital markets. The results of this study reveal that there exists at least one cointegration vector for all six countries. The exchange rate is determined by the PPP relation alone in four of the six countries, Germany, the USA, Italy, and France and by a linear combination of the PPP and UIP relations in Canada. The United Kingdom is the only country that falls outside the linear combination. In the model without trend breaks, the PPP relations hold only for Germany, which indicates that a correct specication of the sampling distribution of the data is important. The paper also considers the one-step prediction based on the ECM representation to check the out-of-sample behaviors of our model. The uctuations of the exchange rate are well predicted by the ECM in the sense that the prediction errors fall in the prescribed range of the condence bands. The sum of the squared prediction error by the ECM outperforms that of a benchmark prediction. The one-step

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157

prediction reveals that the ECM representation is useful to predict out-of-sample behaviors of the exchange rates. The organization of the paper is as follows. In Section 2, we discuss the model of exchange determination and its statistical formulation. A linear combination of the PPP and UIP determines the exchange rates. The statistical model is formulated in the ve-dimensional ECM with some conditioning variables. In Section 3, after a brief description of the data, we present the empirical results for testing the cointegrating ranks and the structural hypotheses. Section 4 examines the one-step prediction based on the ECM representation of the VAR model. In Section 5, we state some concluding remarks. 2. Economic Model and Its Statistical Formulation We construct an exchange rate determination model with the possible interactions in the determination of prices, interest rates, and exchange rates. A simple version of the PPP rate of exchange is dened by et = pt pt , (1)

where et , pt , and pt are the natural logarithm of the spot exchange rate in the domestic currency per foreign currency, the wholesale price index of the home country, and that of the foreign country, respectively. In many existing studies, various price indices are used to test the PPP theory: export prices, prices of tradable goods, wholesale prices, consumer goods prices, and GDP price indices. If all the markets in the two countries are competitive and efcient with few regulations and controls, then the consumer price indices should reect the law of one price. In reality, various regulations in the markets tend to make the movements of the prices of tradable and nontradable goods uncoordinated. Hence, the use of the wholesale price indices (WPI) or GDP deators may be appropriate since they are based on more tradable than nontradable goods. The UIP claims that the exchange rate is determined by et = Et (et +1 ) + it it , (2)

where it and it are nominal interest rates in domestic and foreign currencies, and Et (.) denotes the expected value at time t +1 based on the available information set at time t. The expected rate of depreciation is assumed to be proportional to the gap between the current spot rate and an equilibrium rate (the PPP rate) as proposed by Dornbusch (1976): Et (et +1 ) et = (pt pt et ) , (3)

where is a positive constant. Equation (3) means that the exchange rate is to return to its equilibrium at a rate proportional to the current gap.

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We assume that the exchange rate is determined by a linear combination of the PPP and UIP: et = c1 (Et (et +1 ) + it it ) + c2 (pt pt ) . (4) Notice that Equation (4) breaks down to the PPP if c1 = 0 and c2 = 1, and to the UIP if c1 = 1 and c2 = 0. Although Equation (4) articially tests the PPP and the UIP, it has no economic foundation.1 Substituting Equation (3) into Equation (4), we obtain et = 1 (pt pt ) + 2 (it it ) . (5) where 1 = (c1 + c2 )/(1 c1 + c1 ), and 2 = c1 /(1 c1 + c1 ). Equation (5) reduces to the PPP when 1 = 1 and 2 = 0, and to the UIP when 1 = 1 and 2 = 1/. In Equation (5), the PPP relation is a testable hypothesis, whereas the UIP is not, since is an unknown constant. As is seen from the graphs in the Appendix, the observations on prices, exchange rates, and interest rates in levels are strongly time-dependent. We consider a vector process Xt = [e, p, p , i, i ]t that can provide a satisfactory description of the process in the basic data set. The order of integration of the process Xt as well as the number of stationary relations and common trends can then be determined by analyzing the likelihood function. The stationarity and the non-stationarity hypotheses specied above can be formulated as restrictions on the parameters of the unrestricted model and can be tested using the likelihood ratio procedure. The statistical analysis of the likelihood function will thus provide a consistent framework for the determination of the time series properties of the vector process Xt . Some of the variation in the data is related to various interventions, such as extreme changes of oil prices and structural changes of deterministic trend. Neglect of such extra facts often leads to misspecication of the model. Therefore, the relevant information set has to be enlarged relative to the model, motivated solely by the theoretical arguments. We employ the p 1 VAR model with Gaussian errors as a basic statistical model for the data-generating process: Xt =
1 Xt 1

+ ... +

k Xt k

++

Dt + t ,

t = 1, . . . , T ,

(6)

where Xk+1 , . . . , X0 are xed and 1 , . . . , T are i.i.d. Np (0, ). The vector Dt contains not only nonstochastic variables such as intervention dummies, but also stochastic variables that are difcult to model within the framework of the VAR model. The model (6) will be treated as the benchmark model, within which all of the subsequent hypotheses are tested. We write the model in the error correction form: Xt = Xt 1 +
1

Xt 1 + . . . +
k1 )

k1

Xt k+1 + +

Dt + t .

(7)

The parameters ( 1 , . . . , the process, whereas =

dene the short-run adjustment to the changes of (8)

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159

denes the short-run adjustment () and the long-run relations (). Johansen (1991) shows that if Xt I (1), has the reduced rank of r. The parametrization in Equation (8) facilitates the investigation of the r linearly independent stationary relations between the levels of the variables and the p r linearly independent nonstationary relations. The hypothesis (8) implies that the process Xt is stationary and Xt is nonstationary, but also that Xt is stationary. Thus, we can interpret the relation Xt as the stationary relations among nonstationary variables, i.e., as cointegrating relations. Johansen (1991) and Johansen and Juselius (1990) developed a likelihood procedure for estimating the parameters and testing the order of cointegration rank and the various hypotheses on the restrictions of parameters.

3. Testing the PPP Hypotheses 3.1.

THE DATA

All the quarterly data except for oil prices are taken from the International Financial Statistics CD-ROM (May 1998) compiled by the International Monetary Fund.2 The data series include spot exchange rates (line rf ), wholesale price indices (line 63), and call money rates (line 60b). The sample periods for Japan, the USA, France, Germany, and the UK were 1972.1 to 1996.1, for Canada 75.2 to 96.1, and for Italy 72.1 to 93.3.3 The data cover the period of the post-BretonWoods oating exchange rate system and are illustrated in the Appendix. The data exhibit large uctuations, partly affected by extra factors such as changes in the world oil prices and changes in the institutional restrictions on the capital markets. In order to account for these factors, the price of oil and structural dummies are included in the set of conditioning variables Dt . By inspecting the graphs in the Appendix, we nd that the data do not exhibit a linear time trend over the whole sample period, but show breaks in trend at some sample points. In particular, if we look at the exchange rates and price indices for Japan and the USA, the trend breaks in the prices and interest rates series may have occurred around 1980 and the break in exchange rates around 1985. As for institutional aspects, the US government enforced the depository institutions deregulation and monetary control act of 1980. This event strongly inuenced interest rate determination outside the borders of the USA. On the other hand, in Japan the new foreign exchange and foreign trade control law was enacted in December 1980, and all capital transaction was allowed unless explicitly prohibited. Based on these observations, we assume that the structural changes in the deterministic trend occurred in 1981.1 and 1985.4 in Japan and the remaining six G7 countries.4 Thus, we add the intervention dummies (dum1 and dum2) in the VAR model for each country. The vector Dt is dened by Dt = [ oilt , oilt 1 , dum1t , dum2t ], (9)

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where oilt is the price of oil at time t, dum1t takes 1 after 1981.1 and 0 otherwise, and dum2t takes 1 after 1985.4 and 0 otherwise. The oil price is assumed to be exogenous in the model.5 3.2.
DETERMINATION OF THE LENGTH OF LAGS AND THE ORDER OF COINTEGRATION RANKS

We use the two types of LjungBox tests (hereafter abbreviated as LB tests) based on the residuals for determining the length of lags in the VAR model. The rst one is the multivariate LB test:
[T /4]

LB = T (T + 2)
h=1

1 1 (T h)1 trace( h 0 h 0 ),

(10)

where h = T 1 T=1 t t h , (h = 0, 1, 2, . . .), and t denotes the residuals t obtained from the maximum likelihood (ML) estimation of model (7). The LB statistic in Equation (10) has an asymptotic 2 distribution with p 2 ([T /4] k + 1) pr degrees of freedom (see Hosking (1980) and Hansen and Juselius (1995, p. 73). The second type is the univariate LB test applied for each equation in the VAR model. Starting with k = 1, we sequentially test the uncorrelatedness of residuals in an ascending order until the residuals become uncorrelated. If either the multivariate LB test or the univariate LB test for each of the equations in the VAR model prove to be uncorrelated for a given k, we choose this k. Table I demonstrates the values of the multivariate LB statistics for k = 1, 2, and 3. The values of the univariate LB statistics are omitted for the sake of space. Both of the LB tests reject the null hypothesis of lag 1 for all countries. The multivariate LB test does not reject k = 2 for GE, UK, IT, and FR at the 5% signicance level, while it does reject k = 2 for the USA and CA. The univariate LB test rejects k = 2 for the USA, but not for CA. It does not reject k = 3 for the USA. Hence, we choose k = 2 for GE, UK, CA, IT, and FR and k = 3 for the USA. The estimates of coefcients of the conditioning variables are presented in Table II. Coefcients with a t-value less than one in absolute value have been set at zero to facilitate readability. With regard to the USA, for instance, the lagged differences in oil prices are signicant in four variables out of ve, while the difference is signicant only in one equation. This tendency is commonly observed in all other countries. The dummy variables (dum1 and dum2) representing the breaks of linear trend are signicant at the 5% level in at least one equation for all the countries.6 Oil prices, as a whole, affect the movements of exchange rates, wholesale prices, and interest rates. The intervention dummies seem to improve the tness of the model to the data. In order to determine the order of cointegration ranks, we tested the hypothesis: H1 : rank( ) = r , (11)

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161

Table I. Determination of lag lengths (multivariate LB test) Lag 1 LB 2 LB 3 LB

d.f.

d.f.

d.f.

Country GE a

748.046 (0.00) b 807.18 (0.00) 577.445 (0.00) 713.073 (0.00) 662.302 (0.00) 704.831 (0.00)

550

551.379 (0.21) 565.842 (0.11) 532.489 c (0.00) 616.635 (0.00) 461.79 (0.34) 523.239 (0.51)

525

UK

550

525

CA

475

450 601.62 (0.00)

USA

550

525

500

IT

500

475

FR

550

525

a GE, UK, CA, USA, IT, and FR stand for Germany, the United Kingdom,

Canada, the USA, Italy, and France, respectively.

b The values in parentheses denote p-values. c ( ) denotes that the univariate LB statistic for each of ve equations is (is

not) signicant at the 5% level.

using the two likelihood ratio procedures, the maximum eigenvalue test statistic and the trace test statistic.7 The results are presented in Table III. The two test statistics indicate the same result for all countries except IT. There exist three cointegrating vectors in FR and two in the UK, CA, and the USA at the 5% level. The trace statistic for GE indicates that there is formally no cointegrating vector at the 10% level, although its p-value is very close to 10%. Therefore, we consider that GE has one such vector. For IT, the -max statistic indicates r = 2, but the trace statistic r = 4. Therefore, we decided to use r = 3. Table IV presents the estimated cointegrating vectors. These vectors are the starting point from which to infer the structural hypotheses extracted from the economic theory. 3.3.
TESTS FOR STRUCTURAL HYPOTHESES

This section investigates some economic hypotheses, including those discussed in Section 2. All hypotheses about the PPP and UIP considered in this section have a precise statistical formulation in terms of the cointegration relation and can be validly tested. The following linear hypotheses on the cointegrating vectors are

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Table II. Estimates of exogenous and dummy variables Country GE e oilpt oilpt 1 0.042 (2.010) 0.044 (7.293) 0.015 (5.655) 0.215 (2.827) 0.133 (1.237) 0.175 (2.389) 0.004 (2.236) 0.081 (1.707) dum1t dum2t

0.024 (1.130)a,b 0.017 (2.710) 0.005 (1.900)

0.052 (2.616)

0.024 (1.868)

p p

i i

UK e

0.023 (1.004) 0.014 (2.527) 0.033 (5.963) 0.048 (6.220) 0.179 (3.752) 0.306 (1.780) 0.158 (1.332) 0.005 (1.287)

0.045 (2.801)

p p

0.015 (2.737) 0.125 (2.520)

i i

CA e

0.037 (1.102) 0.023 (3.354) 0.010 (1.958) 0.012 (2.554) 0.091 (1.096) 0.495 (1.584) 0.453 (1.580)

0.052 (1.863)

0.033 (1.890)

p p

0.004 (1.076) 0.161 (2.317)

0.009 (4.009)

i i

0.334 (2.245)

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163

Table II. (Continued) Country USA e oilpt oilpt 1 0.055 (2.213) 0.014 (2.590) 0.005 (1.181) 0.047 (8.573) 0.027 (6.382) 0.237 (3.541) 0.164 (1.301) dum1t dum2t

0.044 (1.946) 0.014 (2.698) 0.006 (1.416) 0.198 (3.222) 0.135 (1.148)

0.026 (1.286) 0.010 (2.304) 0.007 (2.066) 0.157 (2.884)

p p

i i

IT e

0.035 (1.603) 0.020 (3.266) 0.015 (2.143) 0.044 (6.898) 0.048 (6.709) 0.174 (2.355) 0.167 (1.186)

0.030 (1.471)

0.028 (1.697) 0.008 (1.598)

p p

0.011 (1.575)

0.012 (2.192) 0.221 (3.951)

i i

0.523 (3.875)

0.109 (1.026)

FR e

0.066 (2.521) 0.019 (3.038) 0.022 (3.640) 0.040 (6.635) 0.031 (5.149) 0.152 (2.186) 0.243 (2.141) 0.114 (1.012) 0.606 (4.241) 0.031 (4.054) 0.005 (1.037) 0.156 (3.01) 0.209 (2.496)

p p

i i

a The values in parentheses denote the t-values. b To facilitate readability, coefcients with a t-value less than one in absolute

value have been set at zero.

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Table III. Tests of cointegration ranks Rank -Max 1 Trace 1 Resulting ranks

Country GEa UK CA USA IT FR Critical value 10% 5%

24.17 46.52b 51.14b 56.55b 42.70b 41.52b

20.22 41.43b 32.83b 35.99b 39.75b 28.24b

12.34 14.26 13.68 18.76 13.17 24.97b

5.42 3.63 1.38 5.45 9.95 8.56

2.02 1.08 0.03 0.39 7.33 4.92

64.17 106.91b 99.06b 117.15b 102.90b 108.21b

40.00 60.39b 47.92b 60.6b 60.21b 66.69b

19.78 18.96 15.09 24.61 30.46b 38.45b

7.44 4.70 1.41 5.85 17.29b 13.47

2.02 1.08 0.03 0.39 7.33 4.92

1 2 2 2 3 3

YOSHIHIKO TSUKUDA AND TATSUYOSHI MIYAKOSHI

30.90 33.46

24.73 27.07

18.60 20.97

12.07 14.07

2.69 3.76

64.84 68.52

43.95 47.21

26.79 29.68

13.33 15.41

2.69 3.76

a The formal test indicates no cointegration for GE, although the trace statistic for r = 1 is very close to the 10% level. Therefore, b Denotes signicance at the 5% level.

we choose r = 1 for GE.

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Table IV. Estimates of unrestricted cointegrating vectors Country GE UK Rank 1 2 e 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 p 1.106 1.932 0.340 1.465 1.487 1.696 2.044 2.576 4.232 1.068 6.799 0.741 0.874 p 1.109 0.704 0.892 1.585 1.615 1.623 1.544 0.209 1.916 0.901 5.217 0.971 1.178 i 0.043 0.351 0.034 0.178 0.237 0.121 0.194 0.155 0.471 0.029 0.298 0.248 0.016 i 0.074 0.087 0.132 0.082 0.100 0.040 0.009 0.489 0.195 0.011 1.019 0.018 0.018

CA

USA

IT

FR

all structural in the sense that they do not depend on any normalization of the parameter , even though we normalize the coefcient for the exchange rate to be one. Johansen and Juselius (1992) proposed the likelihood ratio (LR) tests for the structural hypothesis. The LR tests have asymptotic 2 distributions under the null hypothesis. In order to identify the cointegration space for each country, we carried out a series of tests for the structural hypotheses. First, we tested the following hypothesis about a single cointegrating vector: H2 : [1, a, a, b, b] Sp(), (12)

where Sp() denotes the space spanned by the column vectors of . This hypothesis means that the exchange rate is determined by a linear combination of the price differential and the interest rate differential in the sense that et a(pt pt ) b(it it ) is stationary. If H2 is rejected, the model in Section 2 does not correctly describe the exchange rate uctuations in the period of the post-BretonWoods system. On the other hand, if H2 is not rejected, the model is consistent with the data. Then, we proceed to a more stringent hypothesis: H3 : [1, 1, 1, 0, 0] Sp(), (13)

which implies that the PPP relation singly holds without any modications by the interest rates.

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Table V. Tests for the rst cointegrating vector Country Rank 2 H2 d.f. 2 1 1 1 a a p-value 2 H3 d.f. 4 3 3 2 2 p-value

GE UK CA USA IT FR

1 2 2 2 3 3

2.48 5.79 0.09 1.56 a a

0.29 0.02 0.77 0.21 a a

2.82 14.38 6.01 0.42 2.91

0.59 0.00 0.11 0.81 0.23

a denotes that the LR test is not available.

Second, in the case that more than one cointegrating vectors existed, we proceeded to test the hypotheses about the second and third cointegrating vectors in addition to the rst cointegration space. According to the empirical results of testing for the rst cointegrating vector, we examined the following two hypotheses: H4 : and H5 : 1 1 1 0 0 1 a a 0 0 Sp(). (15) 1 1 1 0 0 1 a a b b Sp(), (14)

H4 shows that another cointegrating vector exists, consistent with model (5), in addition to the single PPP relation. The hypothesis H5 is nested in H4 and suggests that the exchange rate is proportional to the price differential between the two countries. Finally, we tested the hypothesis about the third cointegrating vector in addition to the rst and second ones. Based on the testing results of the hypotheses H4 and H5 , we chose the hypothesis: 1 1 1 0 0 H6 : 1 a a b b Sp(). (16) 1 c c d d This means that the cointegrating vectors consist of one PPP relation and two other vectors consistent with model (5). Table V shows the results for testing H2 and H3 with regard to the rst vector. The UK rejects H2 . In other words, the UK has two cointegrating vectors, but neither of the two is determined by the linear combination of the PPP and UIP. Three countries, GE, CA, and the USA, accept H2 . The LR test for H2 is not available for IT and FR.

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Table VI. Tests for the second and third cointegrating vectors Country CA USA IT FR Rank 2 2 3 3 Hypothesis H4 : H4 : H4 : H4 : H5 : H6 : 2 12.14 22.68 16.21 3.85 24.35 30.05 d.f. 3 4 2 2 3 2 p-value 0.01 0.00 0.00 0.15 0.00 0.00

We performed the tests on H3 for ve countries other than the UK. GE, the USA, IT, and FR accepted H3 , while CA rejected it. GE had one cointegrating vector, and the PPP relation held. The USA, IT, and FR had at least one PPP relation among two or three cointegrating vectors. We further tested the hypotheses about the second cointegrating vector in addition to the rst vector for the USA, CA, IT, and FR. The results are shown in Table VI. CA has two cointegrating vectors, only one of which is a linear combination of the PPP and UIP; another vector could not be specied. The USA and IT have one PPP relation and no other linear combinations. FR has one PPP relation and one linear combination. Finally, we tested H6 on the third vector for FA. H6 , which is nested in H4 , is rejected for FR. As a result, FR has one PPP relation and one linear combination; the third vector is not identied. Table VII represents the nal estimates of cointegrating vectors for each country with all restrictions imposed by the testing results. We nd that the PPP relation holds in four of the six countries, GE, the USA, IT, and FR, while the linear combination of the PPP and UIP relations determines the exchange rates in CA. Only the UK falls outside the model described in Section 2. We utilize the structure imposed on the cointegration space for predicting the onestep future values of the exchange rates in the next section.

3.4.

THE EFFECT OF TREND BREAKS ON THE PPP RELATIONS

In this subsection, we consider the effect of trend breaks imposed on the VAR model. We analyze the ECM of Equation (7) from which intervention dummies (dum1 and dum2) are removed for the purpose of evaluating the effect of trend breaks on the PPP relations. We carry out the same procedures as those in Section 3.3. Table VIII shows the lag lengths, the order of ranks, and the testing results for the rst cointegrating vector in the model without trend breaks. Both the lag lengths and the order of cointegration ranks of the model happened to be the same

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YOSHIHIKO TSUKUDA AND TATSUYOSHI MIYAKOSHI

Table VII. Estimates of restricted cointegrating vectors Country GE UK Rank 1 2 e p p 1.0 i 0 i 0 0.087 0.132

1.0 1.0 1.0 1.932 1.0 0.340

0.704 0.351 0.892 0.034

CA

1.0 1.612 1.612 0.003 0.003 1.0 0.396 0.227 23.082 10.207 1.0 1.0 1.0 1.0 0.536 0.464 1.0 1.0 1.0 1.0 0.425 1.425 1.0 1.400 0.400 1.0 1.0 1.0 1.000 1.0 4.052 0 0.363 0 7.532 0.117 0 0.105 0 2.898 0.239 0 0.433 -0.048

USA

IT

FR

1.0 0 1.000 0.433 3.052 4.667

Table VIII. Tests for the rst cointegration vector in the model without trend breaks Country Lag Rank 2 H2 d.f. 2 a 1 1 1 1 p-value 2 H3 d.f. 4 1 3 3 3 3 p-value

GE UK CA USA IT FR

2 2 2 3 2 2

1 2 2 2 3 3

2.85 a 9.06 3.59 7.46 0.01

0.24 a 0.00 0.06 0.01 0.9

7.71 6.56 33.53 18.88 10.8 8.65

0.10 0.00 0.00 0.00 0.01 0.03

a denotes that the LR test is not available.

numbers as those of the model with dummies for all six countries. However, the cointegration spaces of the former model are quite different from the latter one. The PPP relation does not hold at the 5% level in ve of the six countries, if we test the hypothesis H3 in the ECM model without trend breaks. Although GE is most favorable for the existence of PPP relation, it exhibits a p-value of 0.1, which indicates near rejection of the PPP hypothesis. Hence, the inclusion of intervention dummies in the VAR model is indispensable to obtain the PPP relations.

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4. One-Step Prediction of the Exchange Rates If the foreign exchange market is weakly efcient in the sense of Fama (1970), the exchange rates follow a martingale process: E{e | I 1 } = e 1 , (17)

where I 1 is the information set available at time 1. The efcient market hypothesis implies that the best predictor of e conditional on the information I 1 is given by E{e | I 1 } = e 1 . The ECM of Equation (7) gives the best predictor of X depending on the information I 1 as E{X | I 1 } = X 1 + X 1 + 1 X 1 + . . . + + k1 X k+1 + + D , (18)

which is different from that of a martingale process. It is interesting to investigate whether or not the prediction by the ECM is better than that by the martingale. We examined the behaviors of one-step predictions based on the ECM representation X = X 1 + ( 1)X 1 +
k1

i ( 1) X 1 + = T0 + 1, . . . , T ,

i=1

(19)

+ ( 1) + ( 1)D ,

where ML estimates are calculated from the data up to time 1. The ML estimates are subject to the rank conditions as well as the structural restrictions determined in Section 3.4. The 95% condence limits of the one-step predictions are approximated by X 1.96{ ( 1)ii }1/2 , (20) where ( 1)ii is the ith diagonal element of estimates of the error covariance matrix. Figure 1 illustrates the behaviors of the one-step prediction for the exchange rates of the six G7 countries. The predictions cover the 20 periods from 1991.2 to 1996.1 for each country (1989.2 to 1993.1 for Italy). For example, the predicted value for the yen/US-dollar exchange rate in the second quarter of 1991 based on the data up to the rst quarter of 1991 is 131.66, the upper (lower) condence limit is 143.47 (120.82), and the actual value at 1991.2 is 138.31. The observed value falls within the condence interval. All of the observed values of the yen/US-dollar exchange rates lie within the condence bands with the exceptions of only 1995.2 and 1995.3. The behavior of the one-step prediction for other exchange rates is similar to that for the USA. The observed values of all the ve exchange rates for the 1995.2 and 1995.3 periods are outside the condence bands. The Mexican currency crisis and the instability of the European currency markets forced a rapid appreciation of the yen against the other G7 currencies in 1995.

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Figure 1. One-step predictions for the exchange rates of Japanese yen per foreign currency.

For instance, the yen was uctuating around 98100/US dollar in February 1995, and hit a post-war high of 79 to the dollar on 19 April. Then, the monetary authorities in the major industrial countries took coordinated actions at the end of May. The value of yen moved back to 95100 by August 1995.8 The exogenous factors for the model such as the Mexican currency crisis and the counteractions coordinated by the monetary authorities in the major industrial countries greatly

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Table IX. The SSPE of the ECM compared with the benchmark prediction Country USA GE CA UK FR IT Benchmark(a) 6.17 102 2.99 102 4.67 102 3.49 103 2.77 10 1.00 103 ECM(b) 5.83 102 2.16 102 5.26 102 2.71 103 2.5 10 0.84 103 (b)/(a) 0.95 0.72 1.13 0.77 0.90 0.84

affected the currency uctuations in these particular periods. The time series model in this paper could not capture this kind of outlier. In fact, the ECM underpredicted the appreciation of yen in 1995.2 and the depreciation in 1995.3. Except for these abnormal periods, the model in this paper satisfactorily predicts the values of the exchange rates three months ahead in the sense that observed values lie within the prescribed range of the condence bands. We compare the sum of squared prediction error (SSPE):
T

SSPE =
=T0 +1

(e | I 1 e )2 ,

(21)

where e | I 1 denotes either the ECM or benchmark predictor of the exchange rate at time based on the data up to time 1. We use the SSPE by the martingale process as the benchmark statistics. Table IX presents the SSPEs of the benchmark and ECM predictions. The SSPE based on the ECM is less than that of the benchmark prediction for ve of the six countries. The ECM exceeds the benchmark only for Canada. Roughly speaking, the ECM representation reduces the SSPE of the benchmark prediction by approximately 10% on average. The results show that the ECM representation is useful in predicting out-ofsample behaviors of the exchange rates of the six G7 countries. We examined only one-step predictions in this section. The multi-period predictions may deserve further consideration. Further theoretical and empirical studies are needed to solve the problems on the prediction of exchange rates. 5. Concluding Remarks The PPP theory claims that the exchange rate between two currencies should be equal to the ratio of their price levels in the long run. Many practitioners in the business world believe that the PPP relation should hold in the long run. When the theory is applied to the real world, however, the relation between exchange

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rates and national price levels can be affected by specications of the sampling distribution of the data. The paper examined the hypotheses of the PPP and UIP relations between the Japanese yen and the other six G7 currencies by using the ECM representation of the ve-dimensional VAR model with structural changes of the trend function in the years 1980 and 1985. The trend breaks were employed in the consideration of institutional aspects of the capital markets. The data covers the periods of the post-BretonWoods oating exchange rate system. The results of this paper are summarized as follows. There exists at least one cointegrating vector for all six countries. The exchange rate is determined by the PPP relation alone in four of the six countries, GE, the USA, IT, and FR, in the sense that the deviation from the long-run equilibrium (et pt + pt ) is stationary. The exchange rate of the Japanese yen against the Canadian dollar is determined by the linear combination of the PPP and UIP, i.e., et a(pt pt ) b(it it ) is stationary. The UK is the only country that falls outside the linear combination. We found that the inclusion of trend breaks into the VAR model is indispensable in obtaining the PPP relations. The result of this paper conrms the claim that a precise specication of the sampling distribution of the data is important to verify an economic theory as emphasized by Johansen and Juselius (1992). This paper also considered the one-step prediction based on the ECM representation in order to check the out-of-sample behaviors of the ECM. The uctuations of the exchange rate were well predicted in the sense that the prediction errors fell in the prescribed range of the condence bands. The ECM dominated the benchmark prediction in terms of the SSPE. We assumed that trend breaks occurred in 1980 and 1985 based on the inspection of the graphs combined with some institutional considerations about the capital markets. This assumption, however, may not be unanimously accepted since we cannot verify that the trend breaks really occurred in these periods. An alternative approach is to choose break points from the data by some statistical procedures. Although we examined only one-step predictions in this paper, the multi-period predictions deserve further consideration. Juselius (1995) found that the vector process is I (2) in the analysis of the multivariate time series model of Danish and German exchange rates, while a linear transformation of variables removes the I (2) trend from the data. Visual inspection of the graphs of our observed data for Japan and the USA appears to have a quadratic trend in some data series, which may imply an I (2) trend. We handled this problem by introducing trend breaks to the I (1) VAR model. However, since the shifts of the constant term may affect the asymptotic distribution of the LR statistic for determining the order of cointegration, strictly speaking, we cannot use the existing table for signicance points. Kunitomo (1996) derived an asymptotic distribution of the LR test statistic for testing the cointegration rank when the deterministic trend has structural changes. However, his formulation of the VAR model does not seem to be applicable to the model in this paper.

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Appendix: Graphs of the Observed Data Series for Each Country

1. Logarithm of exchange rates of Japanese yen per foreign currency.

2. Logarithm of oil prices.

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YOSHIHIKO TSUKUDA AND TATSUYOSHI MIYAKOSHI

3. Logarithm of wholesale price indices (1990 = log(100)).

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4. Interest rates (percent per year).

Acknowledgements The authors are thankful to Hiro Toda and two anonymous referees for their helpful comments. Junji Shimada helped the authors make the tables and gures used in the paper. The research by the second author was supported by a grant-in-aid from the Zengin Foundation for Studies on Economics and Finance in 1996 and a grantin-aid 09630092 from the Ministry of Education, Science and Culture of Japan.

176 Notes

YOSHIHIKO TSUKUDA AND TATSUYOSHI MIYAKOSHI

1. In fact, the linear combination with c1 = 0 and c2 = 0 holds for France, as will be shown in Section 3.3. Although it is admittedly desirable to give an economic foundation to Equation (4), further consideration is needed to answer this question. The referee pointed out that our model implicitly assumes two kinds of agents: the rst one believes in the PPP, the second one in the UIP, and suggested that we study the behavior of these agents in the framework of game theory. However, the game theoretic consideration of our model is beyond the scope of this paper. We leave it for future research. 2. Oil prices are taken from The Data for Energy Statistics: 1997, published by The Institute of Energy Economics Japan. 3. The wholesale price indices for Italy from 1993.4 to 1996.1 are not listed in the International Financial Statistics. 4. We assume that trend breaks occurred in 1980 and 1985 in advance of analyzing the data, although this may not be approved unanimously. An alternative approach is to choose break points from the data using some statistical procedures. This, however, is beyond the scope of the paper. 5. All computations have been performed with the computer package CATS in RATS by Hansen and Juselius (1995). 6. The estimates of coefcients for dummy variables may not obey a standard asymptotic distribution, and t-tests may not be valid even asymptotically. However, we use the t-value as a reference value. We note that signicance at 5% values is also a diagnostic measure. 7. The shifts of constant term affect the asymptotic distribution of the LR statistic for determining the order of cointegration. Strictly speaking, we cannot use the existing table for signicance points, although we rely on the table by Osterwald-Lenum (1992) in this paper. Kunitomo (1996) derived an asymptotic distribution of the LR test statistic for testing cointegration rank when the deterministic trend has structural changes. However, his formulation of the VAR model does not seem to be applicable to the model in this paper. 8. See Monthly Economic Review, (No. 25, 1995, The Bank of Japan) for more detailed facts about the capital markets in these periods.

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