Examining finite-sample problems in the application of cointegration tests for long-run bilateral exchange rates

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Angela Huang
Numerous empirical studies investigate whether exchange rates are related to `economic fundamentals' in the long-run and find a range of relationships through cointegration analysis. We report similar cointegrating relationships for the value of the New Zealand dollar relative to the US dollar (NZD/USD) and for the value of the New Zealand dollar relative to the Australian dollar (NZD/AUD). These include determinants such as commodity prices, 90-day interest rate differentials, and inflation and growth differentials. However, Godbout and van Norden (1997) demonstrate that finite-sample problems may have affected the conclusions of such cointegration studies. Through a simple Monte Carlo study, we consider whether the cointegration coefficients can reasonably be interpreted as `long-run' elasticities of the exchange rate to changes in fundamental variables. The simulation results suggest that given a relatively short span of data it is possible for cointegration analysis to indicate that a long-run relationship has been found when in fact there is only a cyclical relationship. Therefore caution is advised when interpreting the empirical results and making policy assessments about the nature of exchange movements relative to its broad trend.