Time Series Econometrics Course Work 2

Time-Series Econometrics Coursework 2
Name: Alejandro Calaf Fernndez

URN: 6131104
Time Series Econometrics Course Work 2

In this paper, the relationship between exchange rates of two countries and their respective price levels will be
scrutinised. Understanding the adjustment of exchange rate is a crucial for policy makers, since countries with both
fixed and floating exchange rates are interested in knowing what the equilibrium exchange rate would be and what
variation in nominal and real exchange rates they should anticipate.
The natural extension of LOP1, on the economy as a whole, is the Purchasing Power Parity (PPP). It states that the
nominal exchange rate between two currencies should be equal to the ratio of aggregate price levels between two
countries, so that a unit of currency from one country will have the same purchasing power in a foreign country2. In
other words, movements in exchange rates simply denote movements in the price levels (a basket of goods) of two
economies, excluding transaction costs (arising from transport costs, tariffs and nontariff barriers). This relationship
can be described by the following equations:
=
et =Exchange Rate; pt =Price level domestic country; pft =Price level foreign country
= +
After logarithm transformation
For the purpose of model building, it is a necessary condition to test if the series are stationary I(0) or non-stationary
I(d). By inspecting the series, suspicion arises that the series for exchange rates and price levels for both domestic and
foreign countries might be integrated of some order since there is no evidence of mean reversion or timeindependent variance.
Figure 1: Plot of nominal exchange rate series
Figure 2: Plot of domestic price level series
CALAFFERNANDEZ1E
Figure 3: Plot of foreign price level series
CALAFFERNANDEZ2P
10
CALAFFERNANDEZ3PF
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To formally test for the stationarity of these series several tests are performed, namely Augmented Dickey-Fuller
(ADF) test3 and Phillips-Perron (PP) test4.
The Law of One Price (LOP) = theory stating that price of internationally traded goods should be equal anywhere in
the world providing that the price is expressed in a common currency. Results from arbitrage opportunities, where
riskless profit could be obtained by acquiring a product where the price is low and selling it in a location with a higher
price.
2
Alan M. Taylor, and Mark P. Taylor. "The Purchasing Power Parity Debate."
We use the Augmented Dickey-Fuller (ADF) test instead of Dickey Fuller test since the error term in the latter one is
autocorrelated. A parametric way to correct for serial correlation in error term is using ADF test.
4
Phillips-Perron (PP) test corrects the serial correlation in the error term by modifying the test statistic using a nonparametric approach
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Figure 4: ADF test with trend and intercept on nominal exchange rates
Figure 5: ADF test with intercept on nominal exchange rates
All of the three series above behave as a random walk without a drift, implying that while performing a unit root test
a trend should not be included. However, to test if a trend should be included, perform the ADF test with intercept
and trend and check for the significance of the trend coefficient.
In the estimation output in figure 4 the coefficient for @trend(1) is highly insignificant implying that a trend should
not be included in the unit root test for stationarity
In the estimation output in figure 5, the coefficient for the intercept (C) is significant implying that it should be
included for performing an ADF test. The p-value obtained, 0.0026, forces us to reject the null-hypothesis and accept
the alternative hypothesis at a 99% level of confidence. Where the hypotheses are as follow
H0 : series has a unit root = series is non stationary
H1 : series has no unit root = series is stationary
The PP test shares the same hypotheses as the ADF test. In figure 6 the results from this test on nominal exchange
rates including and intercept term are shown. The P-value attained makes us reject the null hypothesis and accept the
alternative hypothesis at a 99% level of confidence5.
It should be noted the both the ADF and PP test are feeble test in the sense that there is a probability of rejecting
the null hypothesis when in fact it is true. Moreover, both test share the disadvantage of sensitivity to structural
breaks (which can be observed in the plot of the series Figure 1, 2 and 3) and lack of power in small samples. In
conclusion, it shouldnt be ruled out that the series are non-stationary.

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Figure 6: PP test with intercept on nominal exchange rates
These tests for stationarity are repeated for the other two variables
present in the model ( and ). As it can be observed from figure 2
and 3, the series seems to display neither a deterministic trend nor
do they seem to be fluctuating around a non-zero mean. This implies
that the aforementioned tests for stationarity should not include a
trend but should include an intercept term. The results for the 3 tests
of stationarity are summarised in table 1 and 2 respectively.
Table 1: Unit root test for calaf2p series (domestic price index)
Table 2: Unit root test for calaf3pf series (foreign price index)
In appendix 3, it can be seen that if an ADF test is performed on the first difference of both series (calaf2p and
calaf3pf), they are rendered stationary. This implies that both series are integrated of order 1 (I(1)) and that the series
are a difference stationarity process (DSP).
A central question for continuing the analysis, is finding whether nominal exchange rates are correlated with past
values of the foreign price index series. This can be formally tested using the Granger Causality test. To perform this
test, a necessary condition is that the series being scrutinised have to display a stationary process. Once results are
obtained, there can be unidirectional and bidirectional causality or independence. Essentially, Granger Causality

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measures whether current and past values of the foreign price index ( ) aid to forecast future values of nominal
exchange rates ( ), or vice versa.
As abovementioned, the series calaf3pf (log of foreign price index) are I(1), this means that if the first difference is
taken on the series it will be rendered stationary. As a result, a new series will be obtained which would be equal to
the change in foreign price index or equivalently the foreign inflation rate. Although this procedure is necessary, by
differencing the series, useful long run information about the causal relationship between the variables is
condemned.
= 1
3 = 3 31
A Vector Autoregressive Model (VAR) has to be estimated to execute a Granger Causality test. A tool used to select
the correct lag length of a given VAR model, is to compare the Akaike, Schwarz and Hannan-Quinn criterion for
models of different lags and select the model that minimises these values. From the results obtained in Appendix 4,
the conclusion is that a VAR(1) model (Appendix 5) should be estimated to carry out the Granger Causality test. In
other words, the model being estimated is of this sort:
11
(
) = (1 ) + (
21
12
1
1
22 ) + (1 ) + (2 )
Figure 8: Granger Causality test on VAR(1) model
The null and alternative hypotheses are:

H0 : 12 = 0 = No causality from 1 to
H1 : 12 0 = Causality from 1 to
Or:
H0 : 21 = 0 = No causality from 1 to
H1 : 21 0 = Causality from 1 to
From the test output in figure 8, it can be concluded that there exists some
degree of causality from nominal exchange rates to changes in the foreign price
index, since 21 is significantly different from 0 (looking at the p-value
0.0130) . Furthermore, the null hypothesis of 12 = 0 is failed to be rejected (p-value 0.6530), ergo concluding that
current values of the nominal exchange rate will not be affected by past values of . These results can be stressed
by looking at the impulse response functions which are used to produce the time path of the dependant variable in a
VAR model to shocks from all the explanatory variables.

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Figure 9: Impulse Response functions for VAR(1) model
From these impulse response functions, it can be seen in the

second panel that the response of nominal exchange rates
(calaf1e) to shocks in the foreign countrys inflation rate
(dcalaf3pf) is 0. Moreover the confidence bands suggest that a
shock to dcalaf3pf will originate a reaction from the nominal
exchange rates not significantly different from 0. These results,
of a flat impulse response function, are consistent from the
ones obtained in the Granger causality test. In the third panel it
can be seen that a shock to nominal exchange rate will result in
a negative foreign countrys inflation rate during the first
period, which will revert to a positive response in the second
period and gradually revert to 0. From the confidence band it
can be concluded that the response of dpft to a shock in et1 will
be significantly different from 0. A positive shock to the nominal exchange rate will depreciate the foreign currency
and ergo reducing price levels (in terms of the domestic currency) in the short run, making foreign goods more
attractive. Through trade, the demand for foreign goods will increase causing an increase in the price level (in terms of
the domestic currency) of the foreign country in the medium term, which will in turn reduce the appeal of foreign
goods internationally.
An important part for testing the validity of the PPP hypothesis, knowing that PPP is a long run condition, is evaluating
the long run relationships between the series being examined, namely price indices and nominal exchange rates.
However, rendering the series stationary through differentiating will jeopardize important long-run information.
The theory states that any linear combination of non-stationary variables will also be non-stationary. Nevertheless, if
the residuals in said linear combination are proven to be stationary it would imply that the series are cointegrated6. It
indicates that the series share similar stochastic trends and since the difference,ut , is stationary they are never
expected to drift too far away from each other. Ergo, there exists a long run relationship between the variables. A
necessary condition for cointegration is that two variables should be integrated of the same order (Appendix 3). To
test for this long run relationship three methods can be used.
Imposing no restriction will lead to estimating a model as such:
= + From this regression the residuals are obtained
= + Implying that the cointegrating vector will be [1, -, ]
This test is formally carried out using the Engle-Granger test for cointegration; however a limitation of Eviews is that
residuals being used for the stationarity test are taken from an OLS regression instead of a DOLS or FMOLS regression.
Hence, the test is carried out manually by saving up the residuals from said regressions and testing their stationarity
with an ADF test. The critical values used to compare the t statistic are found in the Engle-Granger table for residualbased tests.

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Figure 10: Estimation Output for unrestricted model using OLS
By eyeballing the graph of residuals (Appendix 6), it can be conclude

that in the ADF test neither an intercept nor a trend term should be
included. The null and alternative hypotheses of this test are the
following:
H0 : Residual has unit root = Series are not cointegrated
H1 : Residual has no unit root = Series are cointegrated
Comparing the t statistic obtained in the ADF test (Appendix 7), 5.605311, with the critical value at a 95% level of confidence, 3.7429, the null hypothesis is rejected. Ergo, concluding that the residuals are stationary and consequently the series
are cointegrated. The static OLS estimation of the unrestricted model has managed to capture the long run
relationship between the variables. The interpretation is that a 1% increase in the domestic price index will lead to a
1.00798% increase in the nominal exchange rate (in the long-run) and a 1% increase in the foreign price index will
cause a 0.939708% decrease in the nominal exchange rate (in the long-run). Although the OLS estimation is super
consistent7, minimising the variance of residuals, it is biased in small samples.
Figure 11: Estimation Output for unrestricted model using DOLS
A solution, would be estimating the above equation using Dynamic

OLS. It corrects for the endogeneity bias by augmenting the
cointegrating regression with lags and leads8. Once again the graph of
residuals (Appendix 8) displays no evidence that a trend or an
intercept term should be included in the ADF test for stationarity
(Appendix 9). By comparing the t-statistic, -5.453861, with the critical
value at 95% level of confidence, -3.7429, the null hypothesis is once
again rejected. Concluding that the residuals are not stationary, thus
the series are cointegrated and display a long run relationship. The
interpretation of the estimation output in Figure 11 is quite similar to
the previous one. A 1% increase in the foreign price index will lead to
a 1.009270% increase in the nominal exchange rate (in the long run)
and a 1% increase in the foreign price index will trigger a 0.916532%
decrease in the nominal exchange rate (in the long run).
Figure 12: Estimation Output for unrestricted model using FMOLS
Finally, Fully Modified OLS also corrects for the endogeneity bias in a
non-parametric manner, allowing it to be an unbiased and efficient
estimator. The same process as before is carried out where the
residuals are obtained from the FMOLS regression (Appendix 10) and
perform an ADF test (Appendix 11) to test the stationarity of the
residuals. The same conclusion of stationarity in the residuals and
cointegration in the series, ergo displaying a long run relationship, is
attained when the t-statistic, -5.742710, is compared with the critical
value at 95% level of confidence, -3.7429. In figure 12, the values can
be interpreted as a 1% increase in the domestic price index will cause
a 1.015556% increase in the nominal exchange rate, whilst a 1% increase in the foreign price index will trigger a
0.914905 decrease in the nominal exchange rate (in the long run).
7
The estimated value of and converge to the true parameters at a rate of T-1 (faster) instead of T-1/2 with a
consistent estimator.
8
Lags and leads were selected using Schwarz Criterion since it is more lenient with more parsimonious models.

URN: 6131104
In conclusion, these long run relationships are fairly close to the theoretical long run relationship that the PPP
hypothesis predicts (1% increase in domestic price index leading to a 1% increase in nominal exchange rate and 1%
increase in foreign price index causing a 1% decrease in nominal exchange rates), hence the long run PPP hypothesis is
proven using the unrestricted formulation.
A semi restricted formulation of the PPP hypothesis can be used to test for the existence of long run relationship
amongst the variables. The following should be carried out.
Generate series = +
= Where the theoretical cointegrating vector would be [1]
Table 3: Semi-restricted formulation of PPP hypothesis for testing long-run relationship
The above equation is regressed using static OLS,

DOLS and FMOLS. The residuals series from these
regressions is obtained and a test for the
stationarity of the residuals is executed. As
explained before, if residuals are found to not have
a unit root, the series will be cointegrated ergo
implying a long run relationship. The results are
summarised in table 3. Once again, long run PPP
can be confirmed since the theoretical
cointegrating vector is fairly close to the estimated cointegrating vector using static OLS, DOLS and FMOLS [1.094698],
[1.055947] and [1.067874] respectively, since constant is insignificant. The interpretation of the coefficients of are
that a 1% increase in the domestic price index will lead to a 1.094698%, 1.055947% and 1.067874% respective
increase in the foreign price index, in terms of the domestic currency.
A restricted formulation of the PPP hypothesis would be equivalent to generating the following series
= +
A test on the stationarity of the series is carried out. It is observed in figure 13 that the series has no clear trend and
does not wander around a non-zero mean. Thus, proceeding to an ADF test including a constant but without a trend
term.
Figure 13: Plot of generated series
Figure 14: ADF for stationarity on generated series
UT
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From figure 14 it is concluded that the series is
stationary,

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thus once more the long run relationship in the PPP hypothesis is proven. More over the series could be
interpreted as the real exchange rate between the two countries.
I decide to continue my analysis using the unrestricted formulation of the PPP hypothesis since it allows for a clearer
interpretation of the coefficients.
The following step in our analysis is to construct a model that describes the long run and short run behaviour of the
series, as well as the speed of adjustment at which the dependant variable returns to equilibrium when there is a
shock in the explanatory variables and . A model analysing these dynamics is the Error Correction Model
(ECM). The long run relationship will be captured by the equilibrium error, acting as a gravitational pull after a short
run shock, bringing the series back to its equilibrium. The standard OLS is an efficient estimation for this model;
however it requires variables to be stationary. Subsequently, the variables will have to be differenced to render them
stationary.
ECM using static OLS residuals

To estimate the ECM, the first difference of the series , , and to make sure that the series is
stationary, is taken. In the ECM estimation (Appendix 18) 8 difference lags of the series and are
included to make sure all the correlation from residuals is captured. Proceeding, then, to gradually eliminate
the difference lags with higher insignificant coefficients rendering the model to a more parsimonious form.
Caution needs to be taken in this process since it is key to obtain a significant error correction coefficient
(resid_unrestrict_ols(-1)) implying that there is cointegration. Ergo, the following ECM was obtained
(Appendix 19):
= 0 + (__)1 + 0 + 1 +
The coefficient of is -0.269950, implying that 26.995% of a shock in the previous period is corrected in the
current period. Ergo it represents the speed of adjustment in the model. Assuming quarterly data, this means
that it will take roughly 4 quarters (3.704 quarters) to fully adjust from an innovation. The short run effects of
the model are that a 1 percentage point (pp) increase in will lead to a 1.035193pp increase in whilst a
1pp increase in will result in a 1.038185pp decrease in .
ECM using DOLS residuals

The same procedure as before is employed to obtain the ECM using DOLS residuals. The analysis and
interpretation of the coefficients are summarised in table 4.
= 0 + (__)1 + 0 + 1 +
Table 4: Interpretation and explanation of coefficients in ECM using DOLS residuals.

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ECM using FMOLS residuals

Just as before, the same procedure to obtain the ECM using FMOLS residuals was followed. The analysis and
interpretation of coefficients is summarised in table 5.
= 0 + (__)1 + 0 + 1 +
Table 5: Interpretation and explanation of coefficients in ECM using FMOLS residuals.
Obtaining a good forecast model is crucial for any policymaker and economic agent. As explained previously, countries
with different exchange rate regimes, whether these are floating or fixed exchange rates, are interested in obtaining
accurate forecast of the nominal exchange rates so that their monetary policy could be adjusted accordingly.
Moreover the import, export and financial industries rely heavily on currency exchange rates; hence it is in their
interest to obtain precise predictions on nominal exchange rates.
An AR(p) type model is developed to be compared in terms of in sample predictability and out of sample forecasting
ability with the 3 ECMs developed so far. The procedure used to obtain the AR(2) model is descried in Appendix 24.
= 0 + 1 1 + 2 2
A 10-step-ahead forecast is obtained in all 4 models by removing the last 10 observations in the sample and carrying
out again the regression with the reduced sample size. Ergo, the previous models are estimated with a reduced
sample size ranging from observation 1 until observation 190, and the forecast is obtained from observation 191 until
the end of the sample, observation 200.
Figure 15: Forecast ECM using OLS residuals
Forecast: DCALAF1EF
Actual: DCALAF1E
Forecast sample: 191 200
Included observations: 10
Root Mean Squared Error
Mean Absolute Error
Mean Abs. Percent Error
Theil Inequality Coefficient
Bias Proportion
Variance Proportion
Covariance Proportion
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2
0
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191
192
193
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195
DCALAF1EF
196
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2 S.E.
1.029700
0.906036
77.57305
0.203536
0.001017
0.005839
0.993144

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Figure 16: Forecast ECM using DOLS residuals

8
6
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-2
Forecast: DCALAF1EF
Actual: DCALAF1E
Mean Absolute Error
Bias Proportion
Variance Proportion
1.047171
0.920083
78.72245
0.206957
0.000117
0.006496
0.993387
Forecast: DCALAF1EF
Actual: DCALAF1E
Mean Absolute Error
Bias Proportion
Variance Proportion
1.036103
0.913569
76.94243
0.204674
0.000008
0.007325
0.992666
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-6
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192
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2 S.E.
DCALAF1EF
Figure 17: Forecast ECM using FMOLS residuals

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DCALAF1EF
Figure 18: Forecast AR(2) model

6
Forecast: DCALAF1EF
Actual: DCALAF1E
Mean Absolute Error
Bias Proportion
Variance Proportion
-2
2.489271
2.074111
96.19463
0.934155
0.041616
0.819755
0.138629
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DCALAF1EF
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2 S.E.
It is observed that both the root mean squared error (RMSE) and the mean absolute error (MAE) are relatively high
for all 4 models suggesting that the forecast are not close to the observed values. Furthermore, the mean absolute
percentage errors (MAPE) for all the models are once again relatively high. In the AR(2) model, this high value of
MAPE can be explained due to failure in the model to account for the variability in the out-of sample data. In the
ECMs, these values are marginally lower suggesting that ECMs perform better in their forecasting ability.
The Theils inequality coefficients for the ECMs are somewhat close to 0 suggesting that our forecasts obtained
through these models are reliable. Nevertheless, the Theils inequality coefficient obtained through the AR(2) process
is fairly close to 1, indicating that a nave forecast will perform just as well.
Finally, both the bias and variance proportion in the ECMs are quite low, implying that both the forecasted mean and
variance respectively are fairly close to the observed mean and variance. Conversely, the bias and variance proportion
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obtained in the forecast of the AR(2) process are higher, suggesting that this model underperforms in terms of out-ofsample forecasting ability.
In table 6 and 7 a comparison is shown on the performance in terms of insample predictability and out-of-sample
forecasting ability.
Table 6: Model comparison in terms of in-sample predictability
The model preferred in terms of fitting past data is the ECM using FMOLS residuals since it marginally minimises all of
the criteria above.
Table 7: Model comparison in terms of out-of-sample forecasting performance
Nonetheless, in terms of forecasting capacity, it is shown that the model that marginally mimeses most of the criteria
used to measure the forecasting aptitude is the ECM using OLS residuals. This result is consistent with our
expectation, since if and are cointegrated (as it has been shown) OLS is super-consistent. Implying that the
estimated parameter for converges to the true value of at a much faster rate.
The preferred model in terms of both out-of-sample forecasting aptitude and in-sample predictability is the ECM using
FMOLS residuals since it manages to correct the endogeneity bias and serial correlation present in the ECM using OLS
residuals.
Furthermore, it is important to note that neither of the ECMs forecasts have managed to yield a forecast for the
nominal exchange rate close to 1, as the theory predicts. This can be explained by the omission of important variables
in the model such as transportation cost or barriers of trade.
In conclusion, the absolute PPP hypothesis has been proven using the data available. The non stationarity of the series
was tested using unit root tests to both avoid meaningless results in Granger Causality tests and to carry out
cointegration tests when all the series were found to be I(1). Cointegration tests were executed on different
formulations of the absolute PPP hypothesis, where the long run relationship was proven since cointegration vectors
were found to be close to the theoretical ones that the theory predicts. Moreover, having found that the series were
cointegrated, the short run dynamics of the series and the adjustment towards the long run equilibrium was tested by
generating ECMs. Finally, the different ECMs were compared against an AR model in terms of in-sample predictability
and out-of-sample forecasting ability, and it was concluded that the ECMs outperformed the AR model in both.
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Appendices
Appendix 1
ADF test with intercept without trend on calaf2p
PP test with intercept without trend on calaf2p
Appendix 2
ADF test with intercept without trend on calaf3pf
PP test with intercept without trend on calaf3pf
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Appendix 3
1st difference ADF test without intercept or trend on calaf2p
1st difference ADF test without intercept or trend on calaf3pf
Appendix 4
Appendix 5
Lag selection criteria for VAR model
Estimation Output for VAR(1) model
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Appendix 6
Appendix 7
Plot of residuals obtained through unrestricted estimation using OLS
ADF test on residuals of unrestricted model using OLS
RESID_UNRESTRICT_OLS
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Appendix 8
Appendix 9
Plot of residuals obtained through unrestricted estimation using DOLS
ADF test on residuals of unrestricted model using DOLS
RESID_UNRESTRICT_DOLS
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Appendix 10
Appendix 11
Plot of residuals obtained through unrestricted estimation using FMOLS
ADF test on residuals of unrestricted model using FMOLS
RESID_UNRESRICT_FMOLS
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Appendix 12
Appendix 13
Plot of residuals obtained through semi-restricted estimation using OLS
ADF test on residuals of semi-restricted model using OLS
RESID_SEMIRESTRICT_OLS
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Appendix 14
Appendix 15
Plot of residuals obtained through semi-restricted estimation using DOLS
ADF test on residuals of semi-restricted model using DOLS
RESID_SEMIRESTRICT_DOLS
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Appendix 16
Appendix 17
Plot of residuals obtained through semi-restricted estimation using FMOLS
ADF test on residuals of semi-restricted model using FMOLS
RESID_SEMIRESTRICT_FMOLS
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Appendix 18
Appendix 19
8 Difference lag ECM using OLS residuals
Final ECM using OLS residuals
Appendix 20
Appendix 21
8 Difference lag ECM using DOLS residuals
Final ECM using DOLS residuals
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Appendix 22
Appendix 23
8 Difference lag ECM using FMOLS residuals
Final ECM using FMOLS residuals
Appendix 24
Correlogram of
Correlogram of residuals in AR(2) process
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Estimation output in AR(2) process
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Time-Series Econometrics Coursework 2

Name: Alejandro Calaf Fernndez