Abstracts Economics

The present value model of the exchange rate determination

by Ludmila Fedina

In my dissertation, I examine issues of the present value model applied to the exchange rate determination. The first part deals with a shortcoming of the popular Campbell and Shiller test of the present value models. In present value models, expectations of future variables are used to determine the current value of the variables of interest. Campbell and Shiller's technique uses vector autoregressive (VAR) framework and assumes a particular forward looking solution, but rational expectations actually gives rise to an infinite number of solutions. My research reviews this problem and shows that, in the absence of additional assumptions about the agents' information set, it is impossible to discriminate between forward and backward looking solutions and their linear combinations within the VAR framework. In that essay, I also offer possible explanations as to why the restrictions are often rejected. Given the frequent rejection of rationality, the second part revisits the debate between rational and adaptive expectations for pricing the nominal exchange rate. A monetary approach to the exchange rate in a dynamic error-correction framework is used to develop a test for adaptive expectations. Unlike previous work on this problem, I allow for nonstationarity in the data. The restrictions imposed on the data by the rational expectations versus adaptive expectations are tested for several currencies. The model, combined with rational expectations, is rejected for plausible values of the model parameters. However, when combined with adaptive expectations, the model is not rejected in most cases, indicating that adaptive expectations help the model fit the data better than rational expectations. The third part investigates whether structural breaks in exchange rates can reconcile the present value model with rational or adaptive expectations. Unlike previous work, the model tests separately for different sources of breaks: changes in money demand, policy, or expectations. Empirically, my results indicate that breaks in the exchange rate are consistent with adaptive expectations and shifts in the money demand function.