Recent
Published Papers

Taylor Rule Deviations and Out-of-Sample Exchange Rate Predictability

(with Tanya Molodtsova and Onur Ince)

The
Taylor rule has become the dominant model for academic evaluation of
out-of-sample exchange rate predictability. Two versions of the Taylor rule
model are the Taylor rule fundamentals model, where the variables that enter
the Taylor rule are used to forecast exchange rate changes, and the Taylor rule
differentials model, where a Taylor rule with postulated coefficients is used
in the forecasting regression. We use data from 1973 to 2014 to evaluate
short-run out-of-sample predictability for eight exchange rates vis-à-vis the
U.S. dollar, and find strong evidence in favor of the Taylor rule fundamentals
model alternative against the random walk null. The evidence of predictability
is weaker with the Taylor rule differentials model, and still weaker with the
traditional interest rate differential, purchasing power parity, and monetary
models. The evidence of predictability for the fundamentals model is not
related to deviations from the original Taylor rule for the U.S., but is
related to deviations from a modified Taylor rule for the U.S. with a higher
coefficient on the output gap. The evidence of predictability is also unrelated
to deviations from Taylor rules for the foreign countries and adherence to the
Taylor principle for the U.S. *Journal of International Money and Finance*, 2016, 69, pp. 22-44.

Why was the Plaza Accord Unique?

(with Russell Green and Ruxandra Prodan)

This
chapter explores what made the Plaza such a unique combination of strong
cooperation and effective intervention relative to the rest of the post-Bretton
Woods period. We demonstrate that in the first quarter of 1985 the US dollar
was more overvalued in real terms, relative to exchange rates implied by real
interest differentials, for all G-7 economies except Canada, than at any other
time between 1973 and 2005. Further, we use Taylor rules to create a benchmark
for consistency of intervention with monetary policy. We show that foreign
exchange intervention in 1985 was consistent with the direction of monetary
policy prescribed by the deviation of policy rates from the implied Taylor rule
rates for the U.S., but only weakly so for Germany and Japan. This reinforces
the view that the impact of the Plaza on exchange rates derived primarily from
the major policy shift in the U.S. In Fred Bergsten and Russell Green, eds., *International Monetary Cooperation: Lessons
from the Plaza Accord After Thirty Years*, Peterson
Institute for International Economics, 2016, 105-133

Policy Rule Legislation in Practice

(with Alex Nikolsko-Rzhevskyy and Ruxandra Prodan)

The
legislated policy rules proposed by the Federal Reserve Accountability and
Transparency Act of 2014 and the Financial
Regulatory Improvement Act of 2015 have
the potential to transform the conduct of monetary policy. If enacted, the Fed
would have the obligation to explicitly state a benchmark for how the federal
funds rate would respond to variables such as inflation and the output gap that
enter into different variants of Taylor rules. While the Fed would choose its own legislated policy rule, it would be
required to explain deviations from the rule and/or changes to the rule.
Suppose that policy rule legislation
had been in place for the past 60 years. When would the Fed have been in
compliance, and when would there have been deviations from or changes to the rule?
The central result of the paper is that, among the class of rules we consider,
there is no single legislated policy rule that would have avoided large
deviations over extended periods of time. Rules that produce low deviations during most of the 1950s and early 1960s
produce high deviations during the late 1960s and between 1975 and 1985. More
recently, rules that produce low deviations during the first half of the 2000s
produce high deviations during the first half of the 2010s, and vice versa. If
the legislation was adopted and the Fed wanted to avoid deviations from and/or
changes to the rule, this would increase the predictability of monetary policy.
Based on historical and statistical research showing that economic performance is better in
rules-based than in discretionary eras, we believe this would be a desirable
outcome. In John Cochrane and John Taylor, eds., *Central Bank Governance and Oversight Reform*, Hoover Institution
Press, 2016, 57-82

Markov
Switching and the Taylor Principle

(with Chris Murray and Alex
Nikolsko-Rzhevskyy)

Early research on
the *Macroeconomic Dynamics*, 19, June 2015, 913-930

Deviations
from Rules-Based Policy and their Effects

(with Alex
Nikolsko-Rzhevskyy and Ruxandra Prodan)

Rules-based
monetary policy evaluation has long been central to macroeconomics. Using the
original Taylor rule, a modified Taylor rule with a higher output gap
coefficient, and an estimated Taylor rule, we define rules-based and
discretionary eras by smaller and larger policy rule deviations, the absolute
value of the difference between the actual federal funds rate and the federal
funds rate prescribed by the three rules. We use tests for multiple structural
changes to identify the eras so that knowledge of subsequent economic outcomes
cannot influence the choice of the dates. With the original Taylor rule,
monetary policy in the U.S. is characterized by a rules-based era until 1974, a
discretionary era from 1974 to 1985, a rules-based era from 1985 to 2000, and a
discretionary era from 2001 to 2013. With the modified Taylor rule, the
rules-based era extends further into the 1970s and there is an additional
rules-based period starting in 2006. We calculate various loss functions and
find that economic performance is uniformly better during rules-based eras than
during discretionary eras, and that the original Taylor rule provides the
largest loss during discretionary periods relative to loss during rules-based
periods. *Journal of Economic Dynamics and
Control*, 49, December 2014, 4-18

Long-Run Time Series Tests of Constant
Steady-State Growth

(with Ruxandra Prodan)

We propose a new methodology to
study the stability of steady-state growth. Long-run GDP per capita can be
characterized by: (1) the *linear trend
hypothesis*, where there are no long-run changes in GDP levels or growth
rates, (2) the *level shift hypothesis*,
where there are long-run level shifts, but not changes in growth rates, and (3)
the *growth shift hypothesis*, where
there are long-run changes in both GDP levels and growth rates. We formally
test these hypotheses using time series techniques with over 135 years of data.
The results are not favorable to the hypothesis of constant steady-state
growth. While we find evidence supporting the *linear trend hypothesis* for the *level shift hypothesis* for three additional OECD countries, the *growth shift hypothesis* is supported for
seven OECD and four Asian countries. The results are not driven by transition
dynamics. *Economic Modeling*, 42,
2014, 464-474

(with Hatice Ozer Balli and Christian
Murray)

Measuring deviations from Purchasing Power Parity has
been the subject of extensive investigation. The most common practice in
empirical research for measuring real exchange rate persistence is to estimate
univariate autoregressive time series models and calculate the half-life,
defined as the number of periods for a unit shock to a time series to decay by
50 percent. In the presence of structural change, there are two potential
biases in the parameter estimates of autoregressive models: (1) a downward
small sample median-bias and (2) an upward bias which occurs when structural
change is present and ignored. We conduct a variety of Monte Carlo simulations
and demonstrate that the existence of structural change causes a substantial
increase in the small sample bias documented in Andrews (1993). We then propose
an extension of median-unbiased estimation which explicitly accounts for
structural change and apply these methods to estimate half-lives of several
long-horizon real exchange rates analyzed by Lothian and Taylor (1996) and
Taylor (2002). The upward bias from neglecting structural change dominates the
downward median-bias for these real exchange rates. When structural change is
present and accounted for, the median-unbiased half-lives toward a changing
mean decrease and the confidence intervals tighten. *Applied Economics*, 46, 2014, 3300-3311

Taylor’s Rule versus Taylor Rules

(with Alex
Nikolsko-Rzhevskyy)

Does the Taylor rule prescribe negative interest
rates for 2009-2011? This question is important because negative prescribed
interest rates provide a justification for quantitative easing once actual
policy rates hit the zero lower bound. We answer the question by analyzing Fed
policy following the recessions of the early-to-mid 1970s, the early 1990s, and
the early 2000s in the context of both *International Finance*, 2013,
16:1, 71-93

Taylor Rule
Exchange Rate Forecasting During the Financial Crisis

(with Tanya
Molodtsova)

This paper
evaluates out-of-sample exchange rate predictability of Taylor rule models,
where the central bank sets the interest rate in response to inflation and
either the output or the unemployment gap, for the euro/dollar exchange rate
with real-time data before, during, and after the financial crisis of 2008-2009.
While all Taylor rule specifications outperform the random walk with forecasts
ending between 2007:Q1 and 2008:Q2, only the specification with both estimated
coefficients and the unemployment gap consistently outperforms the random walk
from 2007:Q1 through 2012:Q1. Several Taylor rule models that are augmented
with credit spreads or financial condition indexes outperform the original
Taylor rule models. The performance of the Taylor rule models is superior to
the interest rate differentials, monetary, and purchasing power parity models. *International Seminar on Macroeconomics 2012*, Volume 9, July
2013

The (Un)Reliability of Real-Time Output Gap Estimates with Revised Data

(with Onur Ince)

This paper investigates the differences between real-time
and ex-post output gap estimates using a newly-constructed international
real-time data set over the period from 1973:Q1 to 2007:Q2. We extend the
findings in Orphanides and van Norden
(2002) for the *Economic Modeling*,
2013, 713-721

Median-Unbiased Estimation in DF-GLS Regressions and the PPP Puzzle

(with Claude Lopez and Chris Murray)

Using median-unbiased estimation
based on Augmented-Dickey-Fuller (ADF) regressions, recent research has
questioned the validity of Rogoff’s “remarkable consensus” of 3-5 year
half-lives of deviations from PPP. The confidence intervals of these half-life
estimates, however, are extremely wide, with lower bounds of about one year and
upper bounds of infinity. We extend median-unbiased estimation to the DF-GLS
regression of Elliott, Rothenberg, and Stock (1996). We find that combining
median-unbiased estimation with this regression has the potential to tighten
confidence intervals for the half-lives. Using long horizon real exchange rate
data, we find that the typical lower bound of the confidence intervals for
median-unbiased half-lives is just under* *3
years. Thus, while previous confidence intervals for median-unbiased half-lives
are consistent with virtually anything, our tighter confidence intervals are
inconsistent with economic models with nominal rigidities as candidates for
explaining the observed behavior of real exchange rates and move us away from
solving the PPP puzzle. *Applied Economics*,
February 2013, 455-464

Taylor Rules and the Great Inflation

(with Alex
Nikolsko-Rzhevskyy)

Can
U.S. monetary policy in the 1970s be described by a stabilizing Taylor rule
when policy is evaluated with real-time inflation and output gap data? Using economic
research on the full employment level of unemployment and the natural rate of
unemployment published between 1970 and 1977 to construct real-time output gap
measures for periods of peak unemployment, we find that the Federal Reserve did
not follow a Taylor rule if appropriate measures are used. We estimate ** **We also find that the Federal Reserve responded too strongly to negative
output gaps. *Journal of Macroeconomics*, December
2012, 903-918

The Statistical Behavior of GDP after Financial Crises and Severe Recessions

(with Ruxandra Prodan)

Do
severe recessions associated with financial crises cause permanent reductions
in potential GDP, or does the economy return to its trend? If the economy
eventually returns to its trend, does the return take longer than the return
following recessions not associated with financial crises? We develop a
statistical methodology that is appropriate for identifying and analyzing
slumps, episodes that combine a contraction and an expansion, and end when the
economy returns to its trend growth rate. We analyze the Great Depression of
the 1930s for the U.S., severe and milder financial crises for advanced
economics, severe financial crises for emerging markets, and postwar recessions
for the U.S. and other advanced economies. The preponderance of evidence for
episodes comparable with the current U.S. slump is that, while potential GDP is
eventually restored, the slumps last an average of nine years. If this
historical pattern holds, the Great Recession that started in 2007:4 will not
ultimately affect potential GDP, but the Great Slump is not yet half over. *The B.E. Journal *of *Macroeconomics, Special Issue:
Long-Term Effects of the Great Recession*, October 2012, Article 2, 1-29* *

Convergence of Euro Area Inflation Rates

(with Claude Lopez)

(*Journal of International Money and Finance*, 2012, 1440-1458)

We
study the behavior of inflation rates among the 12 initial Euro countries in
order to test whether and when the group convergence initially dictated by the

(with
Tanya Molodtsova and Alex Nikolsko-Rzhevskyy)

*(Journal of Money, Credit, and Banking*, March-April
2011, 535-552)

This paper uses real-time data to
show that inflation and either the output
gap or unemployment, the variables which normally enter central banks’

Out-of-Sample Exchange Rate
Predictability with Taylor Rule Fundamentals

(with
Tanya Molodtsova)

(*Journal of International Economics*, 77, April 2009, 167-180)

Click here for the data and explanation of variable names.

Figures that are discussed but not included in the
text can be found here.

An extensive literature that studied the performance
of empirical exchange rate models following Meese and Rogoff’s (1983a) seminal
paper has not convincingly found evidence of out-of-sample exchange rate
predictability. This paper extends the conventional set of models of exchange
rate determination by investigating predictability of models that incorporate

Taylor Rules with Real-Time Data: A Tale of Two
Countries and One Exchange Rate

(with
Tanya Molodtsova and Alex Nikolsko-Rzhevskyy)

(*Journal of Monetary Economics*, 55, October 2008, S63-S79)

Using real-time data that reflects information available to monetary
authorities at the time they are formulating policy, we find that estimated
Taylor rules based on revised and real-time data differ more for Germany than
for the U.S., Taylor rules using real-time data suggest differences between
U.S. and German monetary policies, and Taylor rules for the U.S. using
inflation forecasts are nearly identical to those using lagged inflation rates.
Evidence of out-of-sample predictability for the dollar/mark nominal exchange
rate with forecasts based on

Restricted
Structural Change and the Unit Root Hypothesis

(with Ruxandra Prodan)

(*Economic Inquiry*, October
2007, 834-853)

In a classic paper, Nelson and Plosser (1982) could not reject the unit root hypothesis in
favor of trend stationarity for 13 out of 14 long-term annual macro series.
Subsequent studies, allowing for one or two structural changes, have found more
rejections with a broken trend stationary alternative. Since these changes are
defined to be permanent, the rejections do not provide evidence of trend
stationarity. We propose new tests for a unit root in the presence of
restricted structural change. Allowing for two offsetting structural changes,
we reject the unit root null in favor of restricted trend stationarity at the
5% significance level for 6 out of 13 series.

(with Natalie Hegwood)

(*Southern Economic
Journal*, July 2007, 104-113)

Rapach (2002) could not reject the unit root null in favor of trend stationarity for four panels of international real GDP and real GDP per capita. Using panel methods that incorporate structural change, we reject the unit root null in favor of the alternative of trend stationarity with a one-time change in either the slope or in both the slope and the intercept for three of the four panels, the exception being the panel with both the fewest countries and the shortest span of data. We conclude that real GDP levels are best characterized as regime-wise trend stationary.

Convergence to Purchasing Power Parity at the Commencement of the Euro

(with Claude Lopez)

(*Review of International Economics*, February 2007, 1-16)

We investigate convergence towards
Purchasing Power Parity (PPP) within the Euro Zone and between the Euro Zone
and its main partners using panel data methods. We find strong rejections of
the unit root hypothesis, and therefore evidence of PPP, in the Euro Zone for
different numeraire currencies, as well as in the Euro Zone plus the

Purchasing
Power Parity and Country Characteristics: Evidence from Panel Data Tests

(with Joseph Alba)

(*Journal of Development Economics*,
January 2007, 240-251)

We examine long-run purchasing power parity (PPP) using panel data methods
to test for unit roots in US dollar real exchange rates of 84 countries. We
find stronger evidence of PPP in countries more open to trade, closer to the

Additional
Evidence of Long Run Purchasing Power Parity with Restricted Structural Change

(with
Ruxandra Prodan)

(*Journal of Money, Credit, and Banking*,
August 2006, 1329-1349)

We investigate two alternative versions of Purchasing Power Parity (PPP):
reversion to a constant mean in the spirit of

The Panel Purchasing Power Parity Puzzle

(*Journal of Money, Credit, and Banking*,
March 2006, 447-467)

Does long-run purchasing power parity hold over the post-1973 floating exchange rate period? Panel unit root tests provide evidence of PPP that increases with the number of observations. The strengthening of the evidence, however, is highly cyclical. When the dollar appreciates at the end of the sample, the evidence of PPP strengthens and, when it depreciates, the evidence weakens. While these patterns cannot be explained by the specifications that are normally used to model real exchange rates, the strengthening, but not the cyclical pattern, can be explained by a specification that incorporates PPP restricted structural change.

(with Jomana Amara)

(*Applied Financial Economics*,
January 2006, 29-39)

We test for Purchasing Power Parity in post-Bretton-Woods real exchange rate data from twenty developed countries using univariate tests and covariate augmented versions of the Augmented Dickey-Fuller (CADF) and feasible point optimal (CPT) unit root tests. The covariates are a combination of stationary variables - inflation, monetary, income, and current account. We perform a cross method comparison of the results. We find very strong evidence of PPP using the CPT test, rejecting the unit root null for 12 out of the 20 countries at the 5% significance level or better, and 6 more at the 10% level. We find much less evidence of PPP with the CADF and univariate tests.

Do Panels Help Solve the Purchasing Power Parity Puzzle?

(with Christian Murray)

(*Journal of Business and Economic Statistics*,
October 2005, 410-415)

While Rogoff (1996) describes the “remarkable consensus” of 3 to 5 year half-lives of purchasing power parity deviations among studies using long-horizon data, recent papers using panel methods with post-1973 data report shorter half-lives of 2 to 2.5 years. These studies, however, do not use appropriate techniques to measure persistence. We extend median-unbiased estimation methods to the panel context, calculate both point estimates and confidence intervals, and provide strong evidence confirming Rogoff’s original claim. While panel regressions provide more information on the persistence of real exchange shocks than univariate regressions, they do not help solve the purchasing power parity puzzle.

Panel Evidence of Purchasing Power Parity Using Intranational and International Data

(with Sarah Culver)

(*International Macroeconomics: Recent
Developments*, Nova Science Publishers, 2006, 39-51)

We investigate purchasing power parity (PPP) with CPI data for Canadian and

The Purchasing Power Parity Puzzle is Worse than You Think

(with Christian Murray)

(*Empirical Economics*, October 2005,
783-790)

The “purchasing power parity puzzle” is the difficulty of reconciling very
high short-term volatility of real exchange rates with very slow rates of mean
reversion. The strongest evidence of
slow mean reversion comes from least squares estimates of first-order
autoregressive models of the long-horizon dollar-sterling real exchange
rate. Using median-unbiased estimation
methods, we show that these methods *underestimate*
the half-lives of PPP deviations, and thus *overestimate*
the speed of mean reversion. When the specification is amended to allow for
serial correlation, the speed of mean reversion falls even further. This makes
resolution of the purchasing power parity puzzle more problematic.

State of the Art Unit Root Tests and Purchasing Power Parity

(with Claude Lopez and Christian Murray)

(*Journal of Money, Credit, and Banking*, April 2005, 361-369)

Although the question of whether
Purchasing Power Parity (PPP) holds in the long run has been extensively
studied, the answer is still controversial. Some of the strongest evidence is
provided by Taylor (2002), who concludes that long-run PPP held over the
twentieth century. We argue that this conclusion is quite sensitive to the use
of sub-optimal lag selection in unit root tests. Using superior lag selection
methods, we find that long run PPP held for the real exchange rates of only 9
out of the 16 industrialized countries in

(with Ruxandra Prodan)

(*Journal of Money, Credit, and
Banking*, June 2004, 423-427)

Unit Roots, Postwar Slowdowns and Long-Run Growth: Evidence From Two Structural Breaks

(with Dan Ben-David and Robin Lumsdaine)

(*Empirical Economics*, February 2003, 303-319)

This paper provides evidence on the unit root hypothesis and long-term growth by allowing for two structural breaks. We reject the unit root hypothesis for three-quarters of the countries n approximately 50% more rejections than in models that allow for only one break. While about half of the countries exhibit slowdowns following their postwar breaks, the others have grown along paths that have become steeper over the past 120 years. The majority of the countries, including most of the slowdown countries, exhibit faster growth after their second breaks than during the decades preceding their first breaks. (Revised: October 2001)

(P. Aghion, R. Frydman,
J. Stiglitz and M. Woodford, eds, *Knowledge,
Information, and Expectations in Modern Macroeconomics: In Honor of Edmund S.
Phelps*, Princeton University Press, 2003, p. 183-187)

The Great Appreciation, the Great Depreciation, and the Purchasing Power Parity Hypothesis

(*Journal of International Economics*, May 2002, 51-82)

Although there has been much recent work on Purchasing Power Parity (PPP), neither univariate nor panel methods have produced strong rejections of unit roots in U.S. dollar real exchange rates for industrialized countries during the post-1973 period. We investigate the hypothesis that these non-rejections can be explained by one episode, the large appreciation and depreciation of the dollar in the 1980s, by developing unit root tests which account for this event and maintain long-run PPP. Using panel methods, we can strongly reject the unit root null for those countries that adhere to the typical pattern of the dollar’s rise and fall.

The Purchasing Power Parity Persistence Paradigm

(with Christian J. Murray)

(*Journal of International Economics*, January 2002, 1-19)

Rogoff (1996) describes the "remarkable consensus" of 3-5 year half-lives of purchasing power parity deviations among studies using long-horizon data. These studies, however, focus on rejections of unit roots in real exchange rates and do not use appropriate techniques to measure persistence. Our half-life estimates explicitly account for serial correlation, sampling uncertainty, and, most importantly, small sample bias. Calculating confidence intervals as well as point estimates for long-horizon and post-1973 data, we find that, even though most of the point estimates lie within the 3-5 year range, univariate methods provide virtually no evidence regarding the size of the half-lives.

The Choice of Numeraire Currency in Panel Tests of Purchasing Power Parity

(with Hristos Theodoridis)

(*Journal of Money, Credit, and Banking*, August 2001, 790-803)

We investigate the implications of the choice of numeraire currency on panel tests of Purchasing Power Parity under the current regime of flexible exchange rates by conducting panel unit root tests with twenty-one different base currencies. We show that the conditions necessary for numeraire irrelevancy are not supported empirically, and that the choice of numeraire currency can and does matter for PPP. The evidence of PPP is stronger for European than for non-European base currencies. Distance between the countries and volatility of the exchange rates are the most important determinants of the results.

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