Exchange Rates and Inflation Rates: Exploring Nonlinear Relationships I.

Introduction:

The theory of purchasing power parity (PPP) is based on the law of one price (LOP), which states that in the absence of transaction costs all identical tradable goods will be priced the same in two different markets if converted into one currency. Any discrepancy in prices of different markets will lead to an arbitrage process which will equalize the prices in both markets. The PPP theory provides the basis for the exchange rate theory and determination of an equilibrium exchange rate. In this way the PPP theory creates a connection between the exchange rate and domestic prices of different tradable goods.

While the LOP provides the basis for the PPP theory, the effectiveness of arbitrage for the reinforcement of LOP is limited. A review of LOP literature shows that there are large discrepancies in the arbitrage process and the process itself is very slow. Among others, Isard (1977), Richardson (1978) and Giovannini (1988) failed to provide support for the LOP and conclude that there exists persistent large deviations from the LOP. As mentioned above the LOP is the main idea behind the PPP theory. Therefore, with the validity of LOP under question; testing the PPP theory is attracting much attention of researchers. A review of literature on PPP reveals that the research is still inconclusive. Empirical studies like Froot and Rogoff (1996), Frankel and Rose (1995) and Mac Donald and Taylor (1992) support a limited version of the PPP theory for certain heavily tradable goods like gold, crude oil, etc. Other studies tested for the hypothesis of mean reversion based on the PPP theory. In an empirical study of cross sectional data, Wei and Parsley (1995) support the mean reversion to the PPP. They study fourteen OECD countries and conclude that the exchange rate deviation from the PPP equilibrium exchange rate takes on average 4.5 years to shrink to the PPP. At the same time there are studies that reject the PPP theory. Goswami (2005) tested the PPP in the black market for eight developing Asian countries and rejected the PPP hypothesis.

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Studies of more integrated markets show quick convergence to the PPP theory. In a study of PPP for the Euro economic zone, Koekijk, Tims and Van Dijk (2004) support the PPP hypothesis and conclude that the gradual economic integration of the euro zone has lead to faster convergence to the PPP. More recently the method of co-integration has been used to test the PPP theory. The method of co-integration better captures an existing relationship between two variables. However, if the relationship between variables is nonlinear and the very source of the nonlinearity is the presence of chaos, then the methods like co-integration tests, correlation coefficients and linear regression used for enquiring about the relationship between exchange rate and price level will fail to detect the nonlinear relationships. Therefore, in this paper, I try to find out if there exist nonlinearity in the time series and if the nonlinearity is consistent with the complex chaotic structure or not. I use monthly data on the bilateral exchange rate of the Czech Koruna (CZK) and Swedish Krona (SEK) against the US dollar and the price levels and apply appropriate AR, ARMA and GARCH models to each times series. Further I test the residuals for the existence of chaos as a source of nonlinearities by applying the Brock, Dechert and Scheinkman (1987) (BDS) tests of chaos. The paper is organized in the following way. Methodology and test for chaos are discussed in section II. Section III explains the data, data sources and brief summary statistics. Empirical findings are presented in section IV and section V concludes the paper.

II. Methodology: I first start analyzing each series of inflation and exchange rates for stationarity by using the Augmented Dickey Fuller test (ADF). Afterwards appropriate autoregressive (AR) and autoregressive moving averages (ARMA) models are estimated for the stationary exchange rate and inflation series. Then Q and Q2 and ARCH tests are applied to test for nonlinearity and conditional hetroskedasticity over time in the mentioned series. The Brock, Dechert and

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Scheinkman (1987) (BDS) test is applied to investigate if chaos is the cause of nonlinearity in the time series or not.

a. BDS Statistics: I apply the BDS test developed by Brock, Dechert and Scheinkman (1987) for detecting different types of nonlinearity including deterministic chaos in a time series. The main idea behind the BDS test is the correlation integral, which measures the frequency of repetition of patterns in a series. Consider a stationary time series Xt=1..T with an m-dimensional space that form M-histories starting at t. A correlation integral function C() is constructed that shows that the probability that the distance between two consecutive arbitrary points on the series is smaller than a small error (). Thus the correlation integral for an embedding dimension M and the smallest distance is given by

CM()= 2TM(TM-1)

M s.s<t TI(XMt, XMs, )

(1)

where TM=T-m+1 and I(XMt, XMs, ) is an indicator function which is equal to 1 if the distance between two consecutive points of the time series is less than the distance and is equal to zero otherwise. The BDS test is applied to test the null hypothesis of independent identical distribution (I.I.D) of the time series. The test shows that if the time series comes from a data generating process, that is, i.i.d, then for any fixed values of M and , then we have

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CM C1(), as T--> .

(2)

The BDS test statistic is given as

BDSM=T [CM-C1]M(),

(3)

where M() is the standard deviation for T CM-C1.

The BDS test is a sided test, and we reject the null hypothesis of i.i.d if the test statistic is greater than the critical values. BDS Critical values are presented by Adrangi et al. (2001a, 2001b). III. Data and Summary Statistics: I use data on prices and monthly bilateral exchange rate series of the CZK and SEK against the USD from January 1993 to April 2011. The data is transformed into percentage change in prices and exchange rates by using the following formula:

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Xt= (ln(Xt/Xt-1)).100, where Xt is the Xt is the monthly value of prices/inflation at month t. The diagnosis of all the series are presented in Table.1. The Augmented Dickey Fuller (ADF) test was applied to test for stationary of the series. All except the inflation (cz) series are found stationary. InflationCZ was transformed by differencing in order to make it stationary. To capture the linear structure of the each stationary time series, appropriate autoregressive (AR) and autoregressive moving averages (ARMA) models are estimated:

ERt(czk)=i=1pai ERt-i(czk) + i,

(4)

ERt(sek)= i=1pai ERt-i(czk) + i,

(5)

INFt(czk)= t+i=1pi INFt-i(czk) + i=1qi t-I,

(6)

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INFt(se)= i=1pai ERt-i(czk) + i,

(7)

where ER(czk) is the percentage change in the monthly exchange rate of CZK against the US dollar and ER(sek) is the percentage change in the monthly exchange rate of SEK against the US dollar. INF(cz) and INF(se) measures the monthly inflation rate in the Czech Republic and Sweden respectively. The Q and Q2 statistics show the linear and nonlinear dependencies in the time series while autoregressive hetroskedasticity effects are shown by the ARCH(6) as presented in Table.1 below.

Table.1 Diagnosis Panel A: Exchange Rates, Monthly Interval: January 1993-April 2011 N=219 CZK Mean -0.248 SD 2.987 ADF -10.975a Q(12) 7.5335a Q2(12) 48.445 SEK -0.072 2.671 -10.115a 17.641b
13.843a

ARCH (6)

32.943a

9.552

Panel B: Inflation Rates, Monthly Interval: January 1993-April 2011 N=219 CZECH REPUBLIC(dinfcz) Mean -0.04 SD 0.952 ADF -7.724a SWEDEN(infse) 0.128 0.435 -2.839c 6|Page

Q(11) Q2(11) ARCH (6)

8.787a 16.932 14.323b

16.569b 5.7332b 7.523

where the CZK and SEK represent the percentage change in the bilateral exchange rate of the Czech koruna and Swedish Krona, respectively, against the US dollar. Infse is inflation in Sweden and the dinfcz series is the differenced series of inflation in the Czech Republic. ADF shows the Augmented Dickey Fuller test for testing the unit root while Q(12) and Q2(12) statistics are the Ljung-Box (Q) tests for autocorrelation of the residuals and square residuals of the time series. Autoregressive conditional hetroskedasticity is shown by ARCH(6), which is chi square distributed with a 6 degree of freedom while a, b, and c show the level of significance at 0.01, 0.05 and 0.1 respectively. It can be seen from the table that the monthly exchange rate show nonlinearities which could be explained by the ARCH effects as the ARCH statistics show the presence of conditional hetroskedasticity for the exchange rate series. From Table.1 above, we see that both the exchange rate of the Czech Koruna and inflation in the Czech Republic shows higher volatility as compared to the Swedish koruna and inflation in Sweden, which is evident from the standard deviation of the percentage change in monthly exchange rate and standard deviation of inflation series.

IV.

Empirical Findings:

BDS Test Results

Results from the BDS (Brock, Dechert and Scheinkman (1987) test are presented in Table.2 for the AR(p) and ARIMA(p,q) series while Table.3 and Table.4 present BDS statistics for the standardized residuals (/h) from the GARCH (1,1) and GARCH (2,2) models, respectively. BDS statistics values are compared to the critical values presented by Adrangi et al. (2001a, 2001b, 2004). In the following tables, where BDS statistics are shown for the appropriate models, the marks a, b and c show 0.01, 0.05 and 0.10 levels of significance for the statistics. 7|Page

Table.2 BDS Statistics for AR(1), AR(1,4) and ARIMA(1,6,1) and AR(1,6) residuals Panel A: Exchange Rates
M /h CZK[AR(1)] 0.25 0.5 0.75 0.99 SEK[AR(1,4)] 0.25 0.5 0.75 0.99 2 0.0036a 0.0089a 0.008 -0.00046 0.00007 -0.0031 -0.0002 -0.0008 3 0.0038a 0.015a 0.027a 0.0003b 0.0006c 0.0030 0.0136a 0.0008a 4 0.0019a 0.0165a 0.042a 0.0007a 0.0002 0.0032 0.0208b 0.0015a 5 0.0010a 0.0141a 0.046a 0.0001 -0.00003 0.0023 0.0232b 0.0022a

Panel B: Inflation Rates M /h CZ[ARIMA(1,6,1) ] 0.25 0.5 0.75 0.99 SE[AR(1,6)] 0.25 0.5 0.75 0.99 2 0.001 0.0012 -0.007 -0.00006c -0.00092 0.002 0.0044 0.0002a 3 0.0009 0.0008b -0.015c -0.00006c -0.00027b 0.0056b 0.014c 0.0005a 4 -0.0006 -0.005 -0.026c -0.000009 -0.000007 0.0056 0.012b 0.0007a 5 -0.0006a -0.0048 -0.036b -0.00015 -0.000007 0.0038 0.010 0.001a

Table.3 BDS Statistics for GARCH (1,1) standardized residuals Panel A: Exchange Rates
M /h CZK-garch11 0.25 0.5 0.75 0.99 SEK-garch11 0.25 0.5 0.75 2 -0.0010 -0.000896 -0.0019 -0.000084 -0.0014 -0.0047 -0.0019 3 0.00075 0.0052 0.0063 0.00013 -0.0004 -0.00082 0.0072 4 0.00122a 0.0055c 0.010 0.0003 -0.00029 -0.00019 0.0091 5 0.000498a 0.0042c 0.010 0.00041 -0.00014 -0.0001 0.0069

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0.99

-0.000084

0.00053a

0.0010a

0.0013a

Panel B: Inflation Rates M /h CZ-garch11 0.25 0.5 0.75 0.99 SE-garch11 0.25 0.5 0.75 0.99 2 0.0023 0.0064 -0.0044 0.00008 0.00027 -0.0032 0.00074 0.00058a 3 0.0018 0.0056 -0.0095 0.00007 0.00020 -0.00065 0.0042 0.00113a 4 0.00041 0.0016 -0.0199 -0.00002 0.00015 0.00049 0.00048 0.00139a 5 0.00009 0.0001 -0.0280c -0.00023 0.00015 -0.00020 -0.0036 0.00206a

Table.4 BDS Statistics for GARCH (2,2) standardized residuals Panel A: Exchange Rates
M /h CZK-garch22 0.25 0.5 0.75 0.99 SEK-garch22 0.25 0.5 0.75 0.99 2 0.0020b 0.0075a 0.0070b 0.000002 0.0011 0.0009 0.0055 0.00001 3 0.0016a 0.0088 0.0127 0.000007 0.0006 0.0014 0.0113 0.00045a 4 0.0010a 0.0065 0.0139 -0.00002 0.00019 0.0023 0.0116c 0.00088a 5 0.0004a 0.0032 0.0106 -0.0004 -0.00014 0.0018 0.0188b 0.0012a

Panel B: Inflation Rates M /h CZ-garch22 0.25 0.5 0.75 2 0.0054c 0.0136c 0.0107 3 0.0034c 0.0149c 0.0177 4 0.00092 0.0123c 0.0256 5 0.0002 0.0094a 0.0308a

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0.99 SE-garch22 0.25 0.5 0.75 0.99

-0.0000 -0.0012 -0.0042 -0.0021 0.00045c

-0.0000 -0.0006 -0.0022 -0.0007 0.00087c

-0.0000 0.00001 -0.0007 -0.0030 0.0010a

-0.0000 0.00018 -0.0004 -0.0040 0.0017a

CZ and SE stand for Czech Republic and Sweden while CZK and SEK stand for Czech Koruna and Swedish Koruna respectively.

From Table.2 above, we can see that the BDS test is greater than the critical values significantly, therefore, we reject the null hypothesis of i.i.d time series and conclude that the residuals of mean equations AR(1), AR(1,4), ARIMA(1,6,1) and AR(1,6) for the series EXCZ, EXSE, DINFCZ and INFSE, respectively, exhibit nonlinearity. However, the nonlinearity in the mean equations is not due to chaos. From Table.3 and Table.4, we can see that the BDS statistics for the standardized residuals from both GARCH (1,1) and GARCH (2,2) models are mostly significant at 0.01 and 0.05. Therefore, we conclude that the there is no nonlinearity in the volatility equations.

V.

Conclusion:

In this paper, I explore the nonlinearities in the bilateral monthly exchange rate of the Czech Koruna and Swedish Krona against the US dollar in relation to inflation in the Czech Republic and Sweden. There has been much interest in the study of PPP theory, however, a research on the PPP theory has largely been inconclusive, I examine the possibility of chaos as the source of nonlinearity in the exchange rates and inflations series. In the presence of chaotic behavior, tests like co-integration tests, correlation coefficients and linear regression will fail to detect the nonlinear relationships. I estimate AR(1), AR(1,4), ARIMA(1,6,1) and AR(1,6) models for EXCZ, EXSE, DINFCZ and INFSE series, respectively, and apply the BDS test to residuals of the above mentioned models and to the standardized residuals of GARCH (1,1) and GARCH (2,2) models to test for chaos. I

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found no nonlinearity in the volatility equations while the mean equations show strong evidence of nonlinear dependencies for both exchange rates and inflations series. However, the nonlinearity in the mean equation is not due to a complex chaotic structure.

Bibliography:
1. Bahram Adrangi, Mary E. Allender and Kambiz Raffiee (2011), Exchange Rates and Inflation Rates: Exploring Nonlinear Relationships Review of Economics & Finance 2011 2. Brock, W.A., Dechert, W., & Scheinkman, J. (1987), A Test of Independence Based on the Correlation Dimension. Unpublished Manuscript, University of Wisconsin, Madison, University of Houston, and University of Chicago. 3. Dickey, David A., and W. A. Fuller, (1979), Distribution of the Estimators for Autoregressive Time Series with a Unit Root. Journal of the American Statistical Association, 74, 427-431. 4. Engel, Charles, Rogers, John H., (1995), Regional Patterns in the Law of One Price: The Roles of Geography vs. Currencies. National Bureau of Economic Research, Inc, NBER Working Papers: 5395. 5. Froot, Kenneth A., Rogoff, Kenneth, (1996), Perspectives on PPP and Long-Run Real Exchange Rates. National Bureau of Economic Research, Inc, NBER Working Papers: 4952. 6. Giovannini,Alberto, (1988), Exchange Rates and Traded Goods Prices. Journal of International Economics, v24, n1/2 45-68. 7. Koekijk, Kees G., Tims, B., Van Dijk, M., (2004), Purchasing Power Parity and the Euro Area. Journal of International Money and Finance, 23(7-8), 1081-1107

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8. Richardson, J. David, (1978), Some Empirical Evidence on Commodity Arbitrage and the Law of One Price. Journal of International Economics, 8 (2), 341-51

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