Multiple Cointegrating Vectors and Structural Economic Models: An Application to the French Franc/U. S. Dollar Exchange Rate

Abstract

Structural models of the exchange rate have performed very poorly for the industrialized nations during the post-Bretton Woods period. The time series behavior of exchange rates seems to conform to other asset prices in that volatility is large and short-term changes seem to respond primarily to the news. Using the Engle and Granger [16] technique, studies by Baillie and Selover [4], Baillie and McMahon [5], and Kim and Enders [21] among others, provided evidence that there are no long-run relationships between bilateral nominal exchange rates and the so-called fundamentals. More recently, papers by Baillie and Pecchenino [6] and Adams and Chadha [1] used the maximum-likelihood Johansen [18] and Johansen and Juselius [19] method to provide evidence of cointegration between exchange rates and some of the fundamentals. However, none of these papers is able to validate any of the standard models of exchange rate determination. Our departure from the previous literature is that we develop a simple modelling strategy that is useful in the presence of multiple cointegrating vectors. In our view, a well specified economic model indicates the number of cointegrating vectors that exist among a set of variables. Moreover, the presence of multiple cointegrating vectors conveys valuable information that should not be wasted. We extend the suggestion of Bagliano, Favero, and Muscatelli [3] and Smith and Hagan [26] and interpret each cointegrating vector as a behavioral or as a reduced form equation from a structural model. The technique is illustrated using U.S./French exchange rate and money market data. In doing so, it is shown that it is not possible to reject a popular structural exchange rate determination model. We demonstrate that in the presence of multiple cointegrating vectors, the theory can guide us in identifying the behavioral equations. The exactly identified long-run relationships can be properly considered to be behavioral equations resulting from a structural model of exchange rate determination. Given that these equations represent long-run properties