David E. Rapach

Testing the monetary model of exchange rate determination: new evidence from a century of data

Abstract We test the long-run monetary model of exchange rate determination for a collection of 14 industrialized countries using data spanning the late nineteenth or early twentieth century to the late twentieth century. Interestingly, we find support for a simple form of the long-run monetary model in over half of the countries we consider. For these countries, we estimate vector error-correction models to investigate the adjustment process to the long-run monetary equilibrium. In the spirit of Meese and Rogoff [Journal of International Economics 14 (1983) 3\24], we also compare nominal exchange rate forecasts based on monetary fundamentals to those based on a naive random walk model.

Forecasting Stock Returns

We survey the literature on stock return forecasting, highlighting the challenges faced by forecasters as well as strategies for improving return forecasts. We focus on U.S. equity premium forecastability and illustrate key issues via an empirical application based on updated data. Some studies argue that, despite extensive in-sample evidence of equity premium predictability, popular predictors from the literature fail to outperform the simple historical average benchmark forecast in out-of-sample tests. Recent studies, however, provide improved forecasting strategies that deliver statistically and economically significant out-of-sample gains relative to the historical average benchmark. These strategies – including economically motivated model restrictions, forecast combination, diffusion indices, and regime shifts – improve forecasting performance by addressing the substantial model uncertainty and parameter instability surrounding the data-generating process for stock returns. In addition to the U.S. equity premium, we succinctly survey out-of-sample evidence supporting U.S. cross-sectional and international stock return forecastability. The significant evidence of stock return forecastability worldwide has important implications for the development of both asset pricing models and investment management strategies.

Forecasting the Equity Risk Premium: The Role of Technical Indicators

Academic research relies extensively on macroeconomic variables to forecast the U.S. equity risk premium, with relatively little attention paid to the technical indicators widely employed by practitioners. Our paper fills this gap by comparing the predictive ability of technical indicators with that of macroeconomic variables. Technical indicators display statistically and economically significant in-sample and out-of-sample predictive power, matching or exceeding that of macroeconomic variables. Furthermore, technical indicators and macroeconomic variables provide complementary information over the business cycle: technical indicators better detect the typical decline in the equity risk premium near business-cycle peaks, whereas macroeconomic variables more readily pick up the typical rise in the equity risk premium near cyclical troughs. Consistent with this behavior, we show that combining information from both technical indicators and macroeconomic variables significantly improves equity risk premium forecasts versus using either type of information alone. Overall, the substantial countercyclical fluctuations in the equity risk premium appear well captured by the combined information in technical indicators and macroeconomic variables. Data, as supplemental material, are available at http://dx.doi.org/10.1287/mnsc.2013.1838 . This paper was accepted by Wei Jiang, finance.

Regime Changes in International Real Interest Rates: Are They a Monetary Phenomenon?

In this paper, we use the Bai and Perron (1998, 2001, 2003) methodology to test for multiple structural breaks in the mean real interest rate for 13 industrialized countries. We find extensive evidence of structural breaks in the mean real interest rate for all 13 countries. In an attempt to explain the breaks in international real interest rates, we also test for multiple structural breaks in the mean inflation rate for the 13 countries. Once again, we find extensive evidence of structural breaks in the mean inflation rate for all of the countries. Interestingly, the breaks in inflation rates and real interest rates often coincide, with increases (decreases) in the mean inflation rate as we move from one regime to the next typically associated with decreases (increases) in the mean real interest rate.

Macro shocks and real stock prices

Abstract In this paper, I examine the effects of money supply, aggregate spending, and aggregate supply shocks on real US stock prices in a structural vector autoregression framework. Overall, the empirical results indicate that each macro shock has important effects on real stock prices. The real stock price impulse responses to the various macro shocks conform to the standard present-value equity valuation model, and they shed considerable light on the well-known negative correlation between real stock returns and inflation. An historical decomposition indicates that the late 1990s surge in real stock prices is due to a series of favorable structural shocks emanating from different sectors of the US economy.

International Evidence on the Long-Run Impact of Inflation

In this paper, I use a structural vector autoregression framework to analyze the effects of a permanent change in inflation on the long-run real interest rate and real output level in 14 industrialized countries. Long-run monetary superneutrality is rejected for all 14 countries using annual data: the results indicate that a permanent increase in inflation lowers the long-run real interest rate in each country; a permanent increase in inflation also increases the long-run real output level in a number of countries. Long-run monetary superneutrality is also rejected for four out of the five countries examined using quarterly data.

Are Real GDP Levels Nonstationary? Evidence from Panel Data Tests

Ever since the seminal paper of, researchers have focused on the potential nonstationarity of important macroeconomic variables, and unit root tests are now a standard procedure in empirical analyses. While there are many findings of unit roots in macroeconomic variables using the popular augmentedtest, this test has low power against near-unit-root alternatives. Recently, panel data procedures have been proposed as an avenue to increased power. This paper applies panel unit root tests to international real GDP and real GDP per capita data. The results overwhelmingly indicate that international real GDP and real GDP per capita levels are nonstationary.

The long-run relationship between inflation and real stock prices

In this paper, we use recent developments in the testing of long-run neutrality propositions to measure the long-run response of real stock prices to a permanent inflation shock for 16 individual industrialized countries. The estimation results provide considerable support for long-run inflation neutrality with respect to real stock prices. Ranges of plausible identifying parameter values are also consistent with a positive long-run real stock price response to a permanent inflation shock. There is little plausible evidence for a negative long-run real stock price response to a permanent inflation shock. Overall, our results indicate that inflation does not erode the long-run real value of stocks.

International Comovements in Inflation Rates and Country Characteristics

Common shocks, similarities in central bank reaction functions, and international trade potentially produce common components in international inflation rates. This paper characterizes such links in international inflation rates with a dynamic latent factor model that decomposes 64 national inflation rates into world, regional, and idiosyncratic components. The world and regional components account for 35% and 16%, respectively, of annual inflation variability on average across countries, so that international influences together explain just over half of inflation variability. The importance of the world and regional components, however, differs substantially across countries. Economic policy choices and development measures strongly explain the cross-sectional variation in the relative importance of international influences. A subsample analysis reveals that the regional (world) factor increases in importance for a number of North American and European (Latin American and Asian) countries since 1980.

States and the Business Cycle

We model the US business cycle using a dynamic factor model that identifies common factors underlying fluctuations in state-level income and employment growth. We find three such common factors, each of which is associated with a set of factor loadings that indicate the extent to which each states economy is related to the national business cycle. According to the factor loadings, there is a great deal of heterogeneity in the nature of the links between state and national economies. In addition to exhibiting geographic patterns, the closeness of state economies to the national business cycle is related not only to differences in industry mix but also to non-industry variables such as agglomeration and neighbor effects. Finally, we find that the common factors tend to explain large proportions of the total variability in state-level business cycles, although, again, there is a great deal of cross-state heterogeneity.