Two essays in international finance

Abstract

Scope and Method of Study:

This dissertation empirically investigates whether Inflation Targeting (IT) policies are related to the validity of Purchasing Power Parity (PPP) and Real Interest Rate Parity (RIP). Each Essay examines each parity with same logic and test methods. In empirical studies of PPP and RIP, several issues have been discussed including choices of price indices and base currencies as well as cross-sectional dependence assumption. PPP and RIP are considered to be contingent upon those factors. This study further explores whether those issues are still important to PPP and RIP when it comes to IT. Quarterly data of 19 OECD countries are sampled under floating rates regime. Different from previous studies that pooled countries into a group (ALL group), this essay further divides them into countries adopted IT (IT group) and countries not adopted IT (NIT group). IPS unit root tests (I'm, Pesaran, and Shin, 2003) and CIPS unit root tests (Pesaran, 2007) are applied to panel data. P-values are taken from nonparametric bootstrap procedure. For IT, ALL, and NIT groups, results are compared based on real exchange rates with CPI and PPI, five different base currencies, and with and without cross-sectional dependence assumption.

Findings and Conclusions:

Results from both essays are consistent. The evidence of PPP and RIP is very strong for IT group no matter what other issue is considered. It suggests IT outweighs other issues when it comes to PPP and RIP. For ALL and NIT groups, results are consistent with previous studies. The choices of price indices and base currencies as well as crosssectional dependence are related to the validity of PPP and RIP to different extent. Moreover, these empirical results match the theoretical findings. Compared to other monetary policies, IT has the ability to adjust inflation rates, real exchange rate, and real interest rate more stable in the long run in response to shocks from rest of the world. IT is highly recommend for its stability effects on those macroeconomic variables. The implications of this study are very intriguing. The initial purpose of authorities to adopt IT might not be to keep PPP or RIP hold for this country. However, based on the findings, IT is unexpectedly related to the validity of PPP and RIP. Supportive evidence can always be found in countries adopted IT. Moreover, under the effect of IT, issues that could explain the failure of PPP or RIP turn to be unimportant. Therefore, compared to previous studies, this study provides a new aspect to explore topics related to PPP and RIP.