International investment positions and exchange rate dynamics: a dynamic panel analysis

Michael Binder and Christian J. Offermanns

No 2007,23, Discussion Paper Series 1: Economic Studies from Deutsche Bundesbank, Research Centre

Abstract: In this paper we revisit medium- to long-run exchange rate determination, focusing on the role of international investment positions. To do so, we develop a new econometric framework accounting for conditional long-run homogeneity in heterogeneous dynamic panel data models. In particular, in our model the long-run relationship between effective exchange rates and domestic as well as weighted foreign prices is a homogeneous function of a country’s international investment position. We find rather strong support for purchasing power parity in environments of limited negative net foreign asset to GDP positions, but not outside such environments. We thus argue that the purchasing power parity hypothesis holds conditionally, but not unconditionally, and that international investment positions are an essential component to characterizing this conditionality. Finally, we adduce evidence that whether deterioration of a country’s net foreign asset to GDP position leads to a depreciation of that country’s effective exchange rate depends on its rate of inflation relative to the rate of inflation abroad as well as its exposure to global shocks.

Keywords: Exchange Rate Determination; International Financial Integration; Dynamic Panel Data Models (search for similar items in EconPapers)
JEL-codes: C23 F31 F37 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba and nep-ifn
Date: Written 2007
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