Measuring and estimating exchange market pressure in the EU

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Abstract

This paper estimates a model of exchange market pressure for several EU currencies vis-à-vis the German mark over the period 1980–94. It differs from previous work in that we use principal components analysis to derive a measure of exchange market pressure, rather than adding exchange rate and reserves changes or using ad hoc weighting schemes. Secondly, we also try to explain movements in our measure of exchange market pressure by a wealth-augmented monetary model. The results suggest that exchange market pressure can indeed be explained by differential money growth, the change in the long-term interest rate differential, real depreciation, budget deficit and the current account for five members of the EU's Exchange Rate Mechanism.

Introduction

The notion of exchange market pressure was introduced by Girton and Roper (1977) to capture the idea that in practice an excess demand or supply of foreign currency could result in both a change in the price of foreign exchange and a change in the level of foreign exchange reserves of the home country. The importance of the concept is that it is equally relevant to all exchange rate systems and to different degrees of exchange rate management. This generality has given rise to an extensive empirical literature including, inter alia, tests on countries as diverse as Canada (Girton and Roper, 1977, Burdekin and Burkett, 1990), Brazil (Connolly and Da Silveira, 1979), Korea (Kim, 1985, Mah, 1991, Mah, 1995), Argentina (Modeste, 1981) and Japan (Lee and Wohar, 1991 Wohar and Lee, 1992). More recently Eichengreen et al., 1994, Eichengreen et al., 1995 have utilized this framework to analyze currency crises by deriving a measure of speculative attacks that excludes devaluations and floatations not taken in a climate of crisis. In contrast, in this paper we attempt to derive a general measure of exchange market pressure which encapsulates both periods of exchange rate crisis and periods of tranquillity within the European Monetary System (EMS).

First, a measure of exchange market pressure is derived from a short-run, wealth-augmented, monetary model of the foreign exchange market. In this model, purchasing power parity is not assumed to hold, domestic and foreign assets are imperfect substitutes and the demands for all assets depend directly upon the real stock of non-bank financial wealth. This gives rise to a different measure of exchange market pressure to that used by Girton and Roper since, as noted by Weymark (1995), measures of exchange market pressure are model-specific. The measure of exchange market pressure includes the change in the interest rate differential, in addition to reserve and nominal exchange rate changes, since as noted by Eichengreen et al., interest rates are frequently changed to alleviate exchange market pressures. Second, and in contrast to Eichengreen et al., we use the technique of principal components to derive the weights and signs to be attached to the three components of the exchange market pressure measure. This has the advantage that we can check the consistency of the signs of each of the components against the theoretical model. A third contribution is to apply this general monetary model to the European Union (EU) currencies over the period of the Exchange Rate Mechanism (ERM) from 1980 to 1994.

The rest of the paper is structured as follows. 2 A model of exchange market pressure, 4 Explaining exchange market pressure: the econometric results sets out the wealth-augmented monetary model of exchange market pressure which encompasses our measure of exchange market pressure. Section 3 uses principal components analysis to derive the measures of exchange market pressure used in the subsequent econometric analysis. Section 4 reports the empirical results from testing the model of exchange market pressure for several EMS currencies over the sample period that runs from 1980 to 1994. Section 5 summarizes the main findings.

Section snippets

A model of exchange market pressure

The demand for domestic real money balances is directly related to the level of real income, the stock of non-bank private sector wealth and the own return on nominal money balances. This latter effect reflects the fact that most money is held in the form of bank deposits that carry a low, but positive rate of interest (see, for example, Fase and Winder, 1993). The demand for real money balances also depends inversely upon the yields of the principal competing assets, which are assumed to be

Measuring exchange market pressure

Prior to estimating (8) we need to derive a measure of exchange market pressure. In this measure only the weight on the change in the short-term interest differential is unknown, therefore one way to proceed would be to estimate the semi-elasticity of money demand with respect to the short-term interest rate (see, for example, Weymark, 1995). As noted by Eichengreen et al. the three variables in the index display significantly different variances, which requires a different approach to ensure

Explaining exchange market pressure: the econometric results

A complete data set is available for five countries, Belgium, France, Italy, Spain and Finland, and covers the entire ERM period up until 1994:4, except for Italy (data end in 1991:4). The model was estimated over the period 1980:3 to 1991:4, leaving 12 quarters for out-of-sample forecast tests. The exchange market pressure series were divided by the weight of the nominal exchange rate change in the index, so as in the theoretical model, emp is now a composite variable with a unit coefficient

Conclusions and final comments

Starting from a wealth-augmented monetary model, we have derived an alternative measure of exchange market pressure using principal components analysis. The results show that it is a defendable measure of pressure in eight out of the 13 European countries in our sample. The model relates the level of exchange market pressure to some macroeconomic variables frequently cited in theoretical work on the genesis of speculative attacks, albeit with opposite effects on exchange market pressure from

Acknowledgements

The authors wish to acknowledge helpful comments from participants at the Western Economic Association Annual conference in Seattle (June 1997) most especially to John Cuddington and Diana Weymark. In addition the editor and an anonymous referee have also helped to improve this paper.

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