This article was downloaded by: [University of Auckland Library]

On: 15 October 2014, At: 16:05

Publisher: Routledge
Informa Ltd Registered in England and Wales Registered Number: 1072954
Registered office: Mortimer House, 37-41 Mortimer Street, London W1T 3JH, UK

International Economic Journal

Publication details, including instructions for authors
and subscription information:
http://www.tandfonline.com/loi/riej20

The Portfolio-Balance Model

of Exchange Rates: Short-Run
Behavior and Forecasting (The
Korean Won/U.S. Dollar Case)
a b
Professor Hong-Ghi Min & Judy McDonald
a
Kyungnam University
b
Lehigh University
Published online: 28 Jul 2006.

To cite this article: Professor Hong-Ghi Min & Judy McDonald (1993) The Portfolio-
Balance Model of Exchange Rates: Short-Run Behavior and Forecasting (The
Korean Won/U.S. Dollar Case), International Economic Journal, 7:4, 75-87, DOI:
10.1080/10168739300000015

To link to this article: http://dx.doi.org/10.1080/10168739300000015

PLEASE SCROLL DOWN FOR ARTICLE

Taylor & Francis makes every effort to ensure the accuracy of all the information
(the “Content”) contained in the publications on our platform. However, Taylor
& Francis, our agents, and our licensors make no representations or warranties
whatsoever as to the accuracy, completeness, or suitability for any purpose
of the Content. Any opinions and views expressed in this publication are the
opinions and views of the authors, and are not the views of or endorsed by
Taylor & Francis. The accuracy of the Content should not be relied upon and
should be independently verified with primary sources of information. Taylor and
Francis shall not be liable for any losses, actions, claims, proceedings, demands,
costs, expenses, damages, and other liabilities whatsoever or howsoever caused
arising directly or indirectly in connection with, in relation to or arising out of the
use of the Content.

This article may be used for research, teaching, and private study purposes.
Any substantial or systematic reproduction, redistribution, reselling, loan, sub-
licensing, systematic supply, or distribution in any form to anyone is expressly
 forbidden. Terms & Conditions of access and use can be found at http://
www.tandfonline.com/page/terms-and-conditions
Downloaded by [University of Auckland Library] at 16:05 15 October 2014
 INTERNATIONAL ECONOMIC JOURNAL
Volume 7, Number 4. Winter 1993

THE PORTFOLIO-BALANCE MODEL OF EXCHANGE RATES: SHORT-

RUN BEHAVIOR AND FORECASTING (THE KOREAN WON/U. S.
DOLLAR CASE)

HONG-GHI MIN*
Kyungnam University
Downloaded by [University of Auckland Library] at 16:05 15 October 2014

JUDY MCDONALD
Lehigh University

This paper studies the relevance of the asset-market model of exchange-rate

determination theory for the Korean won - U. S. dollar exchange rate. We find that
the portfolio-balance model produces better forecasts than the random-walk model
when the structural model is well specified. From this finding, we believe that the
portfolio-balance model can be a good frame of reference for explaining movements
of the Korean won-U. S. dollar exchange rate. We expect that this model will become
increasingly important for the Korean economy, as well as other newly industrializing
countries, as they undergo full scale capital-market liberalization. [F 31, F 471

1. INTRODUCTION

The portfolio-balance or asset-market approach to exchange-rate determination

proposes that the exchange rate, as the domestic price of foreign currency, is
determined as part of the financial market system that brings the demand for an asset
in accordance with predetermined stock supplies. This model was originally
developed by Branson (1977, 1981 and 1983) and empirically investigated by
Branson, et a1 (1977 and 1979) for the U. S. dollar-Deutsche mark rate. Bisignano
and Hoover (1992) extended the asset-market model for the U. S. dollar-Canadian
dollar case and Kearney and MacDonald (1980) for the U. K. pound-U. S. dollar rate.
Considering the recent developments in the Korean foreign-exchange market and
capital market, the background conditions that affect the foreign-exchange market
have changed since 1980. The Bank of Korea adopted the multi-currency pegged
exchange rate system in 1980. Since then the Korean won-U. S. dollar exchange rate
has shown greater variation, because the newly adopted multi-currency exchange rate
system is designed to reflect the demand and supply of foreign currencies in the
foreign exchange market through the adjustment parameter. These changes in Korea's
foreign-exchange market mean that the asset-market approach may be a good way to
model movements in Korea's exchange rate.

*The authors would like to thank the editor and two anonymous referees for their helpful
comments. All remaining errors are our own.
 76 HONG-GHI MIN AND JUDY McDONALD

In this study, we empirically test the asset-market model of the exchange rate to
explain and forecast the monthly Korean won-U. S. dollar exchange rate for the
1980's. As a methodology for testing the asset-market approach, we concentrate on
the forecasting performance of the asset-market structural model. Since moments of
any order (mean and variance etc.) for the estimated coefficients do not exist in the
dynamic simultaneous equations model (see Basmann, 1974) we can not judge
whether estimated coefficients in the system are significantly different from zero. For
the same reason, it is also impossible to judge whether a certain variable has its
Downloaded by [University of Auckland Library] at 16:05 15 October 2014

expected sign. What is more important for the dynamic simultaneous equations
model is the performance of the system as a whole. In this regard, we use a
likelihood-ratio test to evaluate the structural model and to investigate the forecasting
accuracy of the asset-market model for the 1980's Korean won-U. S. dollar rate.
Meese and Rogoff (1983) discuss the fact that a major focus of attention in exchange-
rate economics has been the forecasting performance of different structural models.
The organization of the rest of this paper is as follows. In section 2, we derive an
asset-market model of exchange-rate determination from the financial market's
equilibrium conditions. In section 3, we derive an alternative asset-market model
using the observationally-equivalent transformation of the initial structural model,
since the initial structural model is poorly specified according to the likelihood-ratio
test criteria. Since the alternative model passes the very stringent likelihood-ratio test
and is also found to be dynamically stable, we compare the forecasting performance
of our asset-market structural model with the random walk model. Section 4 presents
the conclusions.

2. THE ASSET-MARKET STRUCTURAL MODEL

A. The Exchange-Rate Equation Derived from the Asset-Market Approach

The common assumptions of the asset-market model of exchange-rate determina-

tion are retained in this study. First of all, the country is small, taking the interest rate
on tradable assets as exogenously determined.
The exchange rate is defined as the domestic price of foreign currency, and in the
short run it is determined in the financial market system as the price that brings the
demand for an asset into accordance with predetermined stock supplies. This study
aggregates earning assets into two categories, domestically-issued assets, H, yielding
domestic interest rate r and foreign-issued assets, F, that earn the foreign interest rate
r* which is fixed in the world market. Domestic portfolio balancers hold a third asset,
domestically-issued money, M. We assume that H and M are non-tradable assets. At
any point in time, the stocks of M, H and F i n the aggregate portfolios of the domestic
private sector are given by history and W stands for total wealth. The asset-market
equilibrium conditions are given as follows (Branson et, al., 1977).
Supply = Demand
 PORTFOLIO-BALANCE MODEL OF EXCHANGE RATES 77
Downloaded by [University of Auckland Library] at 16:05 15 October 2014

The signs of the partial derivatives are listed in each equilibrium condition. The
total differentiation of equations (1) and (2), with (4) written in for W , yields:
A B

where m, is the partial derivative of m with respect to r, etc.

We can rewrite (5) as (6) and use this to solve for deldM and deldF [equations (7) and
(8) below].

since h, > m, and (1 - m) > h (due to adding-up constraint and dominance of own rate
effect).
An increase in the domestic money stock, M, either through a budget deficit or a
swap transaction with foreign assets, directly raises the exchange rate. This increase
in the exchange rate is required for short-run financial market equilibrium.

If the country is running a surplus on its current account, so that net foreign assets,
F, are increasing, this tends to decrease the exchange rate. A country experiencing a
deficit in its current account, with decreasing F, would experience an increase in its
exchange rate. When we move to a bilateral model for a particular rate, for example,
the Korean won/U. S. dollar rate, the natural extension of the. theory is a model that
 78 HONG-GHI MIN AND JUDY McDONALD

includes movements in the Korean and U. S. money stocks as well as net foreign
assets.' We can write down a bilateral2 model for the Korean won/U. S. dollar rate,
where the exchange rate (e) is a function of measures of the U. S. and Korean stocks
of money and net foreign assets, like equation (9):

e(Korean won 1U.S. dollar) = f (M, ,M,, 4 , F,),, (9)

where the subscripts k and a stand for Korea and U. S. respectively. Assuming that
this function is linear, we can write down the estimating equation as equation (10):
Downloaded by [University of Auckland Library] at 16:05 15 October 2014

e(W I $ ) = a, + a,M, + a,M, +a,& + a,F, + u, where u is the random error term. (10)
B. Policy Reaction Functions

In this section we derive a money equation and a policy reaction function for the
policy maker's foreign-exchange market intervention. The policy variables in this
model are assumed to be the authorities' holdings of foreign assets (FG) and the
money stock (M). First, the monetary authority wants to influence domestic financial
conditions, that is, the money supply or the interest rate. Second, the exchange rate
may be a target of policy: targeting the exchange rate is important for a small open
economy that wants to decrease uncertainty in import and export prices. Finally, the
level of official holdings of foreign reserves (FG) may be a target.
The policy maker's objective function takes the form:

Minimize L = w , ( M - M * ) ~ + w , ( F G - F G * ) ~ + w ~ ( ~ - ~ * ) ~
(M,FG)

subject to: (i) M = q(HG + eFG)

(ii) FG = F - FP
(iii) e(Wl$) = a,+a,M, +a,M,+a,F,+a,F,+u

where w , - w, are the weights for each target, a superscript * indicates a target value,
FP is the private holdings of foreign reserves, q is the money multiplier and HG is the

'Omitting the domestic bond stocks for the econometrically spurious reason that the sign of
their coefficients cannot be determined a priori (see Branson, et al., 1977) will, by deleting the
relevant information in the regression, bias the regression coefficients. In spite of this, since
data is not available for the private holdings of the partner country's bond stock, H and H*
could not be included in the estimation.
'A bilateral model, in spite of its generality, does not permit one to assign a priori the sign of
the effect of a change in the asset stocks on the exchange rate (see Bisignano and Hoover,
1982).
31n the short-run analysis of exchange-rate determination, the dynamics of current-account
adjustments are not included in our model. Instead, we concentrate on a purely short-run
horizon in which income and prices are exogenous and the exchange rate is determined simply
by the interaction of asset markets (see Branson, et al., 1977).
 PORTFOLIO-BALANCE MODEL OF EXCHANGE RATES

domestic component of the monetary base.

From the first-order conditions of optimization, we can derive the following asset-
market approach structural model for Korea:
Downloaded by [University of Auckland Library] at 16:05 15 October 2014

where v , - v, represent error terms, b , - b,, c, - c, and a, - a, are the coefficients to be

estimated, and b,, c , and a, are the constant terms.

3. ESTIMATION OF THE INITIAL MODEL AND THE ALTERNATIVE MODEL

A. Data

All stock variables are seasonally adjusted by X-I1 ARIMA, and period averages
are used. Monthly current account data is generated from the quarterly current
account figures based on monthly trade-balance interpolation (Chow and Lin, 1971).
Variable definitions are based on Branson, et al. (1977). See Appendix B for the
definitions of all the variables used. Since the Korean won-U. S. dollar rate has
shown greater variation since 1981,4 we use the period 1981: 10 - 1988: 12 for the
estimation and 1989: 1 - 1989: 12 for the comparison of forecasting accuracy. Since
the target value for the exchange rate and for official holdings of foreign reserves are
not available, we use one period lagged values of the exchange rate and official
reserves as proxies for these variables' target values. For the target level of the money
stock, we convert the target growth rate of the total money stock into the target level
of the monthly money stock (MQ. (The data used in this study will be sent to readers
on request).

B. Estimation of the Initial Structural Model

The money, intervention and exchange-rate equation (11-1 through 11-3) are
estimated using two-stage least squares (2SLS). We include M,(-1) in equation (11-1)
and e(-1) in equation (11-3) to correct serial correlation. Empirical results are
reported in Table 1.

4The Bank Korea imposed new regulations on the exchange position of foreign exchange
banks (called the "overall position management system") in April, 1981 (Kwag, 1989).
'The difference between the likelihood-ratio (LR) test in this paper and the usual specifica-
tion error test is that the LR test in this paper, when combined with the observationally-
equivalent transforrnat~ons,shows us the way to build an alternative model. Also regularity
conditions for the LR test are satisfied, given a normality assumption.
 HONG-GHI MIN AND JUDY McDONALD

Table 1. Estimation of the Structural Model; 1981: 10 - 1988: 12

-
Dependent variable Money Equation (equation 11- 1)

Mk Constant MT Ae(W/$)
,6994 ,01664 -.43567 .99416 Adj R2 = ,9993
(1.2082) i.03178) (.38671) (.03390) D. W = 2.0823
Intervention Equation (equation 11-2) I

1
Downloaded by [University of Auckland Library] at 16:05 15 October 2014

FGk Constant Ae(W/$> m k FG,(-1)

,0877 -. 16628 -.01488 .99604 Adj R2 = ,9847
(.074564) (.043255) (.00480) (.02080) D. W= 1.7248
Exchange Rate Equation (equation 11-3)
e(W/$) Constant M, Ma FPk FP, e(-1)
-1.8667 -.00521 ,03870 .04978 ,00763 .96903 Adj Rz = ,9701
(4.9121) i.0161) (.0313) (.1101) (.00609) (.03968) D. W = 2.2041
Likelihood-ratio test Probability [Chi-squared (9) > 3 1.631 = .2306759* 1@3

Notes: All equations are estimated by 2SLS. Figures in the parentheses are standard errors. Ae
is the first difference of the exchange-rate time series and AM is the difference between targeted
money and the total money stock.

We evaluate the structural model using the likelihood-ratio test5 (see Appendix B
for derivation). The significance probability of this test statistic is less than 1 percent.
Since the likelihood-ratio(LR) test is a model selection criteria (see Min, 1991) poor
support from this likelihood-ratio test does not imply, for the initial asset-market
structural model, the rejection of asset market hypothesis for the 1980's Korean won-
U. S. dollar rate. However this poor support does imply that the initial structural
model is misspecified even though it has microeconomic foundations. Also, since this
initial structural model has poor support from the data, we can not make reliable
statistical inferences.
Because of the poor support from the data, we derive an alternative asset-market
model from the initial structural model. The alternative model has been built using
the observationally-equivalent transformation6 of the initial structural model (see
Basmann, 1988 and Min, 1989, 1991).

C. The Alternative Asset-Market Model

The alternative asset-market model belongs to the same family of asset-market i

6The difference between a rule-of-thumb approach (parsimonious regressions) and this
observationally-equivalenttransformation is that we can maintain the LR test support for the
transformed model, while we may lose a lot of support from the LR test when we rely on the
rule-of-thumb approach.
 PORTFOLIO-BALANCE MODEL OF EXCHANGE RATES 81

models as the initial structural model since it retains all the relevant asset-market
variables. Ilowever, the alternative model is independent of the initial structural
model. This is because all the cross-equation restrictions in the observationally-
equivalent model are removed and thus this alternative model has a better support
from the likelihood-ratio test.
In this section we build an observationally-equivalent model based on the research
question that there is no feedback effect from changes in the exchange rate to the
money supply. According to McNee (1986), the inclusion of exchange rates in the
Downloaded by [University of Auckland Library] at 16:05 15 October 2014

monetary policy reaction function does not increase the explanatory power of the
model.

(1)Derivation of the Transformation Matrix

The first step in obtaining an observationally-equivalent model(0EM) is to derive a

transformation matrix based on the economic restriction that the coefficient of Ae
(W/$) is zero in the money and intervention equations. Second, all "normalizations,"
that is, specifications of 1 in the coefficients matrix of the dependent variables, remain
the same as before. Finally, we put zero restrictions on the coefficients of Korea's
target money, MT, and Korea's actual money, M,, in the exchange-rate equation.
From the solutions for the simultaneous equations, we can calculate the transforma-
tion matrix for the observationally-equivalent model, which is:

( 2 ) Obsewationally-Equivalent Model for the Initial Structural Model

Premultiplying the transformation matrix by the estimated coefficients matrix from

the initial structural model yields the observationally- equivalent model in Table 2.
We can see that this model is observationally equivalent to our initial model since
both models, by design, have the same significance probability from the likelihood-
ratio test. The tiny difference in the coefficients of the dependent variables is caused
by rounding off.

(3)Alternative Asset-Market Model

This model has been constructed from the observationally-equivalent model

derived in the previous section with the following additional restrictions. First, the
cross-equation restrictions embodied in the observationally-equivalent model have
been dropped. ~ e c o n a we
, drop variable whose elasticities are less than .0001. On
this basis, we drop e, e(-1) and FP, from the money and intervention equations; M,
 82 HONG-GHI MIN AND JUDY McDONALD

(-1) and e(-2) from the intervention equation; and FP, from the exchange-rate
equation. The resultant equations are reestimated using 2SLS. In Table 3, we report
the estimation results of the alternative model.
Table 2. Observationally Equivalent Model for the Initial Structural Model:
1981: 10-1988: 12
-. -.

(1) Money equations

.9999Mk= - ,13315 -.00005 e - ,0134 MT + ,0145 Ma - ,0132 FP, - .0005 FP,
Downloaded by [University of Auckland Library] at 16:05 15 October 2014

-1.005 Mk(-1) - ,1274 e(-1) - ,1442 e(-2)

(2) Intervention equation

FGk= -.I1535 + .0032Mk - .00001 e - ,0001 MT + .0086M, - .0078FPk
+ ,0003 FP, + .00004 M,(-1) - .99F G,(-) + ,0754 e(-1) - ,0854 e(-2)
I
(3) Exchange rate equation
.9999e= ,36173 + 1.713FGk + .OOOIMk - .0678Ma + .0614FPk - .0026FP,
,0254 M,(-1) + 1.70 FGk(-1) - 1.59 e(-1) + .6726e(-2)
I
Likelihood-ratio test Probability [Chi-squared(9)> 3 1.631 = .2306759* 10-3

Table 3. Estimation of the Alternative Structural Model; 1981: 10 - 1988: 12

Dependent variable Money Equation (equation 11-1)
M, Constant MT Ma FPa Mk(-l)
-
16.4718 0.0289 - 0.0534 - 0.0218 ,9491 Adj Rz = ,9993
(5.3123) (.03 17) (.0304) (.0071) (.0557) D. W = 2.2937
Intervention Equation (equation 11-2)
FGk Constant AMk FP, Ma e(-1) FG,(-1)
3.0811 0.0217 -.0035 -.0153 ,00028 .9164 Adj R2 = ,9852
(1.0328) (.0058) (.0014) (.0092) (.0258) (.0354) D. W. = 1.8438
Exchange Rate Equation (equation 11-3)
e(W/$) Constant FGk M, FP, G - 1 (-1 e(-2)
7.5451 -.8282 .0210 -.2697 ,6193 1.4549 -.5755 AdjR2=.9971
(2.7371) (.3955) (.0133) (. 1071) (.3222) (.0904) (.0885) D. W = 2.1279
Likelihood-ratio test Probability [Chi-squared(9) > 8.186551 = .5 154614
Notes: All equations are estimated by 2SLS. Figures in the parentheses are standard errors.

From the exchange-rate equation, we can see that Korean private holdings of
foreign reserves (FP,) has the expected sign and the U. S. money stock (M,) has an
unexpected sign. However, as discussed earlier, the means and variances of the
 PORTFOLIO-BALANCE MODEL OF EXCHANGE RATES 83

estimated coefficients do not exist, and we can not judge whether these estimated
coefficients are significantly different from zero based on the reported standard errors.
Since the alternative model has lagged dependent variables in each equation, our
natural concern is the stability of this dynamic system (Samuelson, 1983). Since all
zeros of the characteristic equation lie inside the unit circle of the complex space, the
system is dynamically stable.
When we evaluate the alternative model using the LR test, the probability that chi-
squared(9) is larger than 8.18655 is greater than 50 percent. Since the alternative
Downloaded by [University of Auckland Library] at 16:05 15 October 2014

model is well specified (compared to the initial structural model) and dynamically
stable, we will use the alternative model for forecasting.

(4)Forecasting Perjormance of the Alternative Structural Model

We compare the forecasting performance of the alternative structural model with

that of the random walk model. Meese and Rogoff (1983) as well as Boughton (1984)
found that existing structural models did not outperform the random walk model. In
this study, we perform a dynamic simulation where fitted values are used for the
lagged dependent variables, while actual values are used for the exogenous variables.
For the estimation, data from 1981: 10 to 1988: 12 are used and one-step ahead to
twelve-step ahead simulation is performed. For this simulation, the twelve-step ahead
forecast is for 1989: 12 and the one-step ahead forecast is for 1989: 1.
In Table 4, we report the root-mean-squared error (RMSE)7 and the mean-absolute
error (MAE)8of the structural model and the random walk model.

Table 4. Forecasting Accuracy of the Asset-Market Model; 1989: 1-1989: 12

Time Horizons ' 1 month 3months 6 months 12 months
-- -
RMSE
Asset-Market Model ,3487 ,4672 1.4118 1.5760
Random Walk Model ,3801 1.2384 2.0644 2.0895
MAE
Asset-Market Model ,3487 ,4136 1.1715 1.3495
Random Walk Model ,3801 1.1025 1.8733 1.9766

From Table 4, we can see that the asset-market model, which has good support from
the likelihood-ratio test, forecasts better than the random walk model. From this, we
can see that the structural model derived from the asset-market approach to exchange-
rate determination is useful for forecasting.

7~MS= E JC(Yf--, where Yf is the simulated value and Yo is the actual value of
value of the exchange rate-index, and T is the number of periods in the simulation.
RMAE f 0 ~ / y awhere
= x ~ y- y , variable definitions are the same as in footnote 7 above
 HONG-GHI MIN AND JUDY McDONAiD

4. CONCLUSION

This study has constructed an asset-market model for the Korean won-U. S. dollar
exchange rate to study the forecasting accuracy of the structural model. An
observationally-equivalent transformation of the initial structural model was used to
build an alternative structural model and this alternative model was used for the
dynamic simulation. One important empirical finding in this study is that the asset-
market structural model provides better forecasts of the monthly Korean won-U. S.
Downloaded by [University of Auckland Library] at 16:05 15 October 2014

dollar exchange rate than the random walk model. This implies that the asset-market
model has good support from the 1980's Korean won-U. S. dollar rate when the
structural model is properly specified. We can also conclude that the foreign-
exchange market interventions by the Korean monetary authority during the 1980's
were fairly efficient and they successfully compensated the excess demand and excess
supply conditions of Korea's foreign exchange market. In future research we plan to
develop a comprehensive vector-autoregression model to increase the explanatory
power of our results. Based on the findings in this paper, we expect that the asset-
market approach will provide superior forecasting as well as a better explanation of
exchange-rate movement under the market average exchange-rate system when
Korea's full-scale capital-market liberalization is initiated.

APPENDIX A

SOURCES AND DEFINITIONS OF THE MONTHLY VARIABLES

IFS: International Financial Statistics;

SCB: Survey of Current Business;
M, = Korean money supply in Won (source: IFS, line 34b);
F, = International reserves of Korea in dollars (source: IFS line 1 1.d plus line 1 and)
minus cumulated SDR allocations (source: IFS line 78bd);
e = Korean wonIU. S. dollar exchange rate, index 1970 = 100 (source: IFS line ah);
MT = Target Central Bank Money in Won (we convert the target growth rate of the
total money stock announced by the Minister of Finance into the target level of the
money stock, source: Monthly Report of the Fiscal statistics);
Ma = U. S. Money Supply in dollars (source: IFS line 34b);
FP, = Private net Foreign Asset Stock of the United States in dollars:
FP, = (1) - ( 2 ) + (3);
(1) = Total Net Foreign Asset Stock of the United States: cumulated current
account (source: IFS line 77 ad) on the benchmark figure (source: Survey of
Current Business, 1011975). The monthly current account figures are interpolated
using monthly trade account figures as reference series;
(2) = International reserves of the United States in dollars (source: IFS line 1 1.d
plus line 1 and);
 PORTFOLIO-BALANCE MODEL OF EXCHANGE RATES

(3) = Cumulated SDR allocations (source: IFS 78bd);

FP, = Private Net Foreign Asset Stock of Korea in dollars;
FP, = (1) - (2) + (3);
(1) = Total Net Foreign Asset Stock of Korea in dollars: cumulated current account
on benchmark figure converted into dollars using Korean won/U. S. dollar
exchange rate defined above;
(2) = International reserves of Korea in dollars (source: IFS line 1 Id plus line 1
and);
Downloaded by [University of Auckland Library] at 16:05 15 October 2014

(3) = Cumulated SDR allocations (source: IFS line 78 bd).

APPENDIX B

For the simultaneous equations model, structural equations can be written as in

equation (1):
(I) B'Y + C'Y + U = 0, where Y is a vector of dependent variables and X is a vector of
predetermined variables. E(UIU) = Q, which is the cross-equation variance-
covariance matrix of the structural model, and E(U) = 0, that is, error terms are
assumed to have normal distributions. The reduced form equations for this structural
model can be written as follows:
(2) Y = X P + E, where E(EE) = S, which is the cross-equation variance-covariance
matrix of the reduced from equations. S can be calculated from the reduced-from
estimation (by OLS). Parameter estimates are denoted by hats ("). Unconstrained
statistics for the reduced form equation (2) are
(3) P,^, = (XfX)-IXfY, (4) SLn = (I/ T)(Y - Xci)'(Y - XP,'), where T is the number of
observations. The likelihood for the unconstrained model evaluated at Pu^,, SLn is
n , X,Y) = d e t ( ~ ^ u n ) - ~ ' ~ .
(5) ~ ( ~ " u shun;

The constrained statistics for the structural form equation (1) estimated by 2SLS are

The likelihood for the constrained model evaluated at P,^,, s;, is

From (5) and (8), the likelihood - ratio test statistic can be written as follows

(9) - 2 ~ 0 gA,, = -T*LO~

This statistic has asymptotically a x2 distribution with degrees of freedom equal to

the number of overidentifying restrictions in the structural model.
 HONG-GHI MIN AND JUDY McDONALD

REFERENCES

Basmann, R. L., "Causality Tests and Observationally Equivalent Representation of

Econometric Models,' Journal of Econometrics, November 1988, 69-105.
, "Exact Finite Sample Distributions for Some Econometric Estimators
and Test Statistics: A Survey and Appraisal,' in M. D. Intrilligator and D. A.
Kenderick eds., Frontiers of Quantitative Economics, ed. by, 209-288, 1974.
Bisignano, J. and Hoover, K., "Some Suggested Improvements to a Simple Portfolio
Downloaded by [University of Auckland Library] at 16:05 15 October 2014

Balance Model of Exchange Rate Determination with Special Reference to the U.

S. DollarICanadian Dollar Rate,' Weltwirtschaftliches Archiv, Vol. 118, No. 1,
1982, 19-37.
Boughton, J. M., "Exchange Rate Movements and Adjustment in Financial Markets;
Quarterly Estimates for Major Currencies,' IMF Staff Papers, September 1984,
445-468.
Branson, W. H., "Asset Markets and Relative Prices in Exchange Rate Determination,
' Sozialwissenschafiliche Annalen, Vol. 1, No. 1, 1977, 69-89.
, "Macroeconomic Determinants of Real Exchange Rates,' NBER
Working Paper, No. 801, Cambridge, MA: NBER, 1981.
, "A Model of Exchange Rate Determination with Policy Reaction:
Evidence from Monthly Data,' NBER Working Paper, No. 1135, Cambridge, MA:
NBER, 1983.
Branson, W. H., Halttunen and P. Masson, "Exchange Rates in the Short-Run: The
DollarIDM rate,' European Economic Review, December 1977,302-324.
, "Exchange Rates in the Short-Run: Some Further Evidence,'
European Economic Review, October 1979,395-402.
Chow, G. C., and An-loh Lin, "Best Linear Unbiased Interpolation, Distribution, and
Extrapolation of Time Series by Related Series,' Review of Economics and
Statistics, November 1971, 372-375.
Kearney, C., and MacDonald, R., "A Structural ~ d r t f o l i oBalance Model of the
Sterling-Dollar Exchange Rate,' Weltwirtschaftliches Archiv, Vol. 116, No. 3, 478-
495.
Kwag, D. H., "Foreign Exchange Market in Korea,' Monthly Review of the Korea
Exchange Bank, September 1989, 3-13.
McNee, S. K., "Modelling the Fed: A Forward-looking Monetary Policy Reaction
Function,' New England Economic Review, Boston, MA: Federal Reserve Bank of
Boston, 1986,3-24.
Meese, R. A,, and K. Rogoff, "Empirical Exchange Rate Models of the Seventies-Do
They Fit Out of Sample?,' Journal of lnterrzational Economics, February 1983, 3-
24.
Min, H. G., "Observational Equivalence and the Asset-Market Model of Exchange-
Rate Theory,' Unpublished Ph. D., Dissertation at the State University of New
York at Binghamton, 1989.
, "The Use of Observational Equivalence in Search of Alternative
 PORTFOLIO-BALANCE MODEL OF EXCHANGE RATES 87

Causal Hypotheses of Simultaneous Equations Models,' A Paper Presented at the

Third Far Eastern Meeting of the Econometric Society held at Seoul University,
Seoul, Korea, 1991.
Samuelson, P., Foundations of Economic Analysis, Cambridge, M A : Harvard
University Press, 1983, 380-439.
Downloaded by [University of Auckland Library] at 16:05 15 October 2014

Mailing Address: Professor Hong-Ghi Min, Department of International Economics,

Kyungnam University, Masan-si, Kyeong-Sang Nam-do, 630-701, KOREA.
Mailing Address: Professor Judy McDonald, Economics Department, Rauch Business
Centre, Lehigh Uni~,ersity,
Bethlehem, Pennsylvania 18015-3144, U. S. A.