PPP and the Monetary Model of Exchange-Rate …PPP and the Monetary Model of Exchange-Rate Determination:... 133 However, the float of the Singapore dollar since 1973 has been in a

PPP and the Monetary Model of Exchange-Rate Determination:The Case of Singapore

Cao Yong&

Ong Wee Ling

Nanyang Business School, Nanyang Technological University, Nanyang Avenue, Singapore 2263Fax: +(65) 792.4217, Tel: +(65) 799.1322, Email: [email protected]

Abstract This study examines the Purchasing Power Parity (PPP) model and the Monetary model for theSingapore-US exchange rate. Results of the cointegration analysis reveal that the exchange rate is inagreement with relative PPP. However, there are serious doubts about the monetary model’s ability toexplain the movements of the Singapore-US exchange rate. Error-correction models for both PPP andmonetary models are presented to take into consideration short-run dynamics in modelling exchange rates inthis study.

1 INTRODUCTIONEconomists have tried without success to capture the fundamentals that led to fluctuatingexchange rates. Of the many theories that evolved are Purchasing Power Parity and theMonetary approach to the determination of exchange rates. PPP represents the classicalmonetary case, where national price levels are linked by the nominal exchange rate. TheMonetary Model seeks to explain movement of the exchange rate in relation to relativemoney supplies while assuming that non-money assets are perfect substitutes.

There is differing empirical evidence on both PPP and the monetary models of exchange-rate determination. In particular, the monetary model has performed poorly on estimationas well as on out-of-sample forecasts (MacDonald and Taylor (1992a)). The monetaryapproach of exchange rate determination has received a lot of coverage in the literature aswell as has been subjected to a lot of empirical testing. Empirical support for the monetarymodel appears to break down after 1978. Thus, it would be interesting to test the validityof the monetary model in the Singapore context. This study will investigate both thevalidity of PPP and monetary model as long-run relationships in Singapore. To do so,tests of cointegration are designed to detect the presence or absence of a long-runequilibrium among time series. Temporary departures from equilibrium are possible andcan be represented by an error-correction mechanism which reflects the short-rundynamics. Thus, an attempt in formulating error-correction models for both PPP andmonetary model is made using Engle-Granger two-step methodology.

The rest of the paper is organised as follows. Section 2 briefly summarises the conduct ofexchange rate policy and monetary policy in Singapore. The unique features of theSingapore economy and why the authorities decided to switch to a strong dollar policy in1981 are discussed. Section 3 gives a review of Purchasing Power Parity, the MonetaryModel and some past empirical studies. In particular, the Flexible Price Monetary Modeland the Real Interest Differential Monetary Model will be discussed in detail. A briefdiscussion on cointegration and error-correction models is also included. Section 4analyses the exchange rate and monetary variables in the estimation model. It traces thegradual appreciation of the Singapore-US bilateral rate as well as the key trends of theinterest rate, money supply and income between Singapore and the US. The data set used,cointegration tests, estimation results and error-correction models are presented in section

132 Cao and Ong

5. The relative PPP model performed relatively well as compared with the monetarymodel. The section then discusses some reasons why exchange rate movements may notfollow predictions of the monetary model. Principal conclusions are drawn in the finalsection.

2 EXCHANGE RATE POLICY AND MONETARY POLICY IN SINGAPOREDue to historical links with Great Britain, Singapore adopted a fixed exchange rate systemwhere the Singapore dollar was pegged to the pound sterling upon its independence in1965. During that period of time, there were also strict regulations on capital flowsbeyond the Sterling Area Territories.

In November 1967, the sterling was devalued following its balance of paymentsdifficulties. At that time, only half of Singapore’s foreign reserves were in sterling asSingapore had been diversifying its foreign resources since July 1966 by investing in non-sterling countries such as the United States, West Germany, Switzerland and France.Singapore decided against devaluation, following Britain’s devaluation because the gain inthe competitiveness upon devaluation was not great. Most of Singapore’s raw material,machinery and investment goods were imported from non-devaluing countries such asJapan, West Germany and Thailand. If Singapore devalued its currency, then there wouldhave been a huge jump in import prices. The cost of living would have increased due tohigher wages demanded by workers which would have taken the form of higher prices.Furthermore, these imports were rather demand inelastic; there is little possibilty ofimport-substitution.

The instability of prices and wages brought about by devaluation would have offset anyinitial favourable effects devaluation in the long-run. It would have also discouragedforeign investment in Singapore. Since the domestic sector at that time was small, theadvantage of devaluation on exports, balance of payments and income was small.Similarly, as the sector of home production was small, any stimulating effect on import-substitution was negligible.

The authorities also decided at the same time to peg the Singapore dollar to the US dollarand gold, while still maintaining pound sterling as their intervention currency. However,following the floating of the sterling in June 1972, the authorities changed theirintervention currency from sterling to the US dollar. This was to avoid the difficulties inusing sterling pound as an intervention currency because of the heavy speculation againstpound at that time. Furthermore, many countries in the region (e.g. Indonesia, Thailandand Philippines) and in the world used the US dollar as their intervention currency. Thedecision to adopt the US dollar as the intervention currency integrated Singapore into thefinancial arena, laying the foundation for the development of a international financialcentre in later stages. In addition, the exclusion of Singapore from the Sterling Area led tosubsequent gradual liberalisation of exchange controls.

During the period following the devaluation of the US dollar in February 1973, there was ahuge inflow of funds into Singapore. As Singapore was still under a fixed exchange rateregime, the authorities had to buy the excess US dollar at the ‘floor rate’ and this wasequivalent to taking a stance of devaluation. In order not to subject the economy to animported inflationary threat (and thus, accumulating unnecessary large amounts of USdollars), the authorities decided to float the Singapore dollar on 20 June 1973.

PPP and the Monetary Model of Exchange-Rate Determination:... 133

However, the float of the Singapore dollar since 1973 has been in a state of managed or‘dirty’ float. Thus even now, the Singapore dollar is pegged to an undisclosed trade-weighted basket of currencies of her major trading partners. The objective is to allow thedollar to fluctuate within a certain band which the authorities consider not too high toimpede the growth of exports and not too low that it increases import prices, resulting ininflationary pressures. This is a wise policy from the viewpoint of trade and investmentsbecause wide exchange rate fluctuations are avoided, boasting business confidence inSingapore.

On 1 June 1978, exchange controls were completely liberalised, against a backdrop ofstrong economic performance and as part of the measures to develop Asian Dollar Market.The liberalisation made it possible for Singapore residents and corporations to makepayments in all currencies and invest in any country outside Singapore without anyrestrictions. Foreign investments and repatriation from Singapore could also be madewithout any exchange rate formalities. It also allowed non-trade transactions in the forwardexchange market and foreign and offshore banks were also allowed to deal in the foreignexchange market (MAS Annual Report 1978/79).

The total relaxation of the exchange controls was the final step in the process of gradualliberalisation of exchange controls to facilitate capital movements and trade transactionswith an increasingly integrated financial world. The domestic financial market was mademore responsive to developments in other financial markets and world events as a result.

In 1981, the MAS ushered in a new policy regime aimed at ‘maintaining a strong exchangerate for the Singapore dollar’ (MAS Annual Report 81/82). The new policy was adoptedamidst an inflationary external environment. The aim of the policy is to maintain stableprices to achieve sustainable economic growth. The MAS argued that the exchange ratepolicy would be a more effective tool to fight against imported inflation. The decision wasmade after considering openness and high import dependence of the Singapore economy.A strong Singapore dollar would guard against imported inflation and keep the costs ofproduction low.

The exchange rate policy also played a complementary role in the upgrading andrestructuring of the economy. A strong dollar would reduce the price of capital goods andcosts of automation, which would develop the high value-added, high tech and knowledge-intensive industries. In addition, a strong and stable Singapore dollar is a good indicator ofa conducive investment climate instilling confidence in local and foreign investors.Foreign depositors and borrowers would be confident in the financial transactions carriedout in Singapore; this would enhance Singapore’s position as a leading internationalfinancial centre.

In the 1990s, the strong dollar policy pursued by MAS continued to play an important role.Besides neutralising foreign inflationary pressures, the strong Singapore dollar helped tocool the overheated tight labour market.

Traditionally, Singapore had a fixed exchange rate from its colonial past. However, sincethe float of the Singapore dollar in 1973, Singapore has in general adopted a managed floatexchange rate system. The openness and smallness of the domestic economy made itvulnerable to wide fluctuations in the exchange rate if the Singapore dollar were to floatfreely. Speculative forces in the market would also add to the uncertainty if it were a cleanfloat. The rationale behind the managed system of foreign exchange in Singapore is tomaintain a certain band such that the real effective exchange rate would be stable. As a

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result, export growth would not be hindered by the reduction in competitiveness andimport prices would not rise so much as to trigger high inflation in Singapore. Thissuggests that the bilateral exchange rate between Singapore and the US may be closelyrelated to inflation rates in both countries.

The Monetary Authority of Singapore is the de facto central bank in Singapore. It wasestablished under the MAS Act 1970. It was officially operative on 1 January 1971. Itperforms all functions of a central bank in Singapore, except that of issuing andredemption of currency.

The MAS is guided by the philosophy of maintaining stability of the Singapore dollar toensure non-inflationary economic growth in the country. Thus, the MAS intervenes in themarket whenever speculative forces exert pressure on the Singapore dollar to move off itstarget band. The MAS intervenes by selling (buying) Singapore dollars in the market tocause its depreciation (appreciation). It is through this indirect way which the MAS utilisesmarket forces to align the exchange rate within the target range.

The exchange rate is pegged to an undisclosed basket of trade-weighted currency of itsmajor trading partners and competitors. It is allowed to fluctuate within a target bandwhich is changed form time to time, depending on prevailing and projected future levels ofworld inflation, domestic inflation and policy considerations. The weights are also variablereflecting changes in trading partners and competitors. Thus the MAS has a certain degreeof discretion in determining the target zone.

Although a strong exchange rate will keep inflation at bay, but at the same time, it willaffect the short-run competitiveness of the exports abroad. However, the authority stronglybelieves that a weaker exchange rate aimed at promoting export competitiveness will onlycreate a ‘temporary’ advantage for Singapore exporters. This is because the weakerexchange rate will result in higher inflation (due to increasing wages and the high importcontent of the exports), and this will eliminate the initial gains in competitiveness.

The MAS is also responsible for the formulating and implementing of monetary policies inSingapore. This will discussed in greater detail in the next section. The MAS plays a keyrole in the supervision and regulation of the financial system in Singapore. This is toensure that the integrity and confidence in the financial sector is safeguarded, therebypromoting and developing Singapore as an international financial centre.

Since the 1970s, monetary policy in Singapore is mainly aimed at promoting economicgrowth and stabilising the economy. For example, in the inflationary period of 1972 to1974, the MAS increased the cash reserves ratio from 3½ per cent to 9 per cent in 1973and at the same time, curbed external fund inflow into the banking system by introducing aspecial deposit ratio of 5 - 9 per cent.

The major instruments of monetary policy in Singapore are foreign open marketoperations, domestic open market operations, reserve requirements and discount rates.Sometimes, moral suasion and selective controls are also used in the short-run.

Singapore’s monetary policy is centred on managing the exchange rate. In 1981, the MASofficially announced that they would target the exchange rate to maintain a strongSingapore dollar. The open and small nature of Singapore economy means that Singaporecannot dictate world prices. Coupled with the high import content of exports, this makesthe domestic prices vulnerable to changes in the exchange rate or world prices. Thus,


managing the exchange rate is considered the most effective tool to maintain price stabilityin the country.

Monetary policies involving interest rates and the money supply are not effective as theydo not influence economic activities. High levels of foreign investment in Singapore limitsthe role that interest rates can play to influence the costs of domestic borrowing. Inaddition, the lack of restrictions on capital inflow and outflow and the high mobility ofinterest-rate sensitive capital make it difficult to target either the money supply or interestrates.

One unique feature of the Singapore economy is the liquidity drain on the financial systemby the mobilisation of funds by the public sector through compulsory CPF contributionsand POSB savings. This is further compounded by the budgetary surplus that thegovernment enjoys from year to year. Thus the government has to reinject liquidity into thedomestic banking system in order to avoid a sharp contraction of liquidity and anappreciation of the Singapore dollar. One way to do so is for the MAS to purchase foreignexchange in the market (i.e. sell Singapore dollars), thus increasing the money base (uponwhich the banking system creates credit). Therefore, monetary policy in Singaporedepends on management of the exchange rate.

In conclusion, exchange rate management and monetary policy in Singapore have a closeand unique relationship. Price stability is the prime objective. High inflation will erode thevalue of the country’s reserves and bring about social conflicts which are undesirable tothe economy. Thus emphasis of the monetary policy is placed on countering inflationaryeffects.

3 MODELLING EXCHANGE RATE DETERMINATION

Among all theories of determination of the exchange rate, PPP and monetary models havegenerated a vast amount of literature and empirical results. However, results have beendiffering and sometimes, even controversial. This section examines the theories andempirical evidence of PPP and monetary models.

3.1 PURCHASING POWER PARITY

Purchasing Power Parity (PPP) is a theory of exchange rate determination. It asserts thatthe exchange rate between two currencies over any period of time is determined by thechange in the two countries price levels. As this theory singles out changes in price levelsas the overriding determinant in the determination exchange rate, it is also called the‘inflation theory of exchange rates’.

Versions of PPP theory can be traced to the sixteenth century in Spain and England.However, it was Cassel (1916, 1918, 1919, 1922), a Swedish economist, who popularisedthe use of PPP. Cassel in 1918 realised that exchange rate in the short run would divergefrom PPP and identified 3 disturbances (actual and expected inflation, barriers to trade andshifts in international movements of capital) which might have caused these deviations.However, he concluded that these shocks were transitory and did not analyse the PPPdisparities.

There can be many reasons why deviations from PPP occur. Firstly, there may berestrictions on trade and capital movements or transfer pricing in a country which will

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distort the relationship between home and foreign prices. Secondly, speculative activitiesand official intervention may create a PPP disparity. Lastly, the productivity bias whenthere is a relatively faster growing productivity growth in the tradable sector than in thenon-tradable sector will result in systematic divergence of internal prices (Balassa (1964)).

The basic concept underlying PPP is that arbitrage forces will equalise prices of goodsinternationally if they are measured in the same currency. Basically there are two forms ofPPP : absolute and relative.

In the absolute version of PPP, the nominal exchange rate is determined by the ratio ofdomestic and foreign prices. That is,

S = P/P* (1)

where S is the exchange rate measured as the domestic currency price of a unit of foreigncurrency and P and P* are the domestic and the foreign price indices respectively. Bytaking logarithms of equation (1), the absolute PPP theory can be rewritten as :

st = pt - p*t (2)

where the lowercase notations denote logarithms of the variables.

The absolute version of PPP is highly unlikely to hold because of the existence oftransportation costs, imperfect information and the distorting effects of tariffs andprotections. Thus, it is argued that a weaker relative version of PPP, known as the relativePPP, can be expected to hold even in the face of these distortions.

The relative version of PPP dictates that the percentage change in the exchange rate isequal to the difference in the inflation rates between the two countries. That is,

%∆S =%∆P - %∆P* (3)

where %∆S is the percentage change in exchange rate, %∆P is the domestic inflation rateand %∆P* is the foreign inflation rate. For empirical testing purposes, we can estimateequation (3) by the following,

∆st = α + β(∆pt -∆p*t) (4)

where lowercase notation imply logarithms of the variables.

Empirical studies have yielded mixed results for the support of PPP. McNown andWallace (1989) tested PPP for Argentina, Brazil, Chile and Israel for the 1970s and 1980sand found support for PPP. On the other hand, Bahmani-Okolee (1993) found that PPPholds for only four out of twenty-five developing countries.

Although there are disputes on the validity of PPP as a short-run relationship, there seemsto be a general agreement that PPP will hold in the long-run. Thus, if a long-runrelationship exists, then logarithms of the nominal exchange rate and the price levelindices should move together over the long-run.

Cointegration is a technique to determine whether two or more time series have a long-runrelationship. It allows the long run relationship between exchange rates and relative pricesto be tested independently of short-run fluctuations. Firstly, there is a need to establish theorder of integration for the time series of the exchange rate and prices.


The exchange rate and relative prices are said to be stationary, if they tend to constantlyreturn to their means even though they fluctuate around their means. The test of the orderof integration can be found by the following equation for each of the variables,

∆Xt = βo + β1Xt-1 + γi

k

=∑

1i∆Xt-i + µt (5)

where ∆ is the first difference operator.

If β1 < 0, then Xt is stationary. If β1 = 0, then Xt is non-stationary. The hypothesis is that β1 = 0 is tested by t-ratio. The ratio is an Augmented Dickey-Fuller (ADF) if some lags arerequired on the right hand side to make the residuals, µt, white noise (i.e. k ≥ 1). It is aDickey-Fuller (DF) test if no lags are required (i.e. k = 0). No equilibrium will existbetween variables that are integrated of different orders. As far as PPP theory is concerned,if the exchange rate and relative prices have a long-run relationship, they should have thesame order of integration.

Next, based on the Engle-Granger two-step method, the dependent variable (that is, theexchange rate) is regressed on the independent variables (e.g. relative prices). The test ofcointegration involves testing whether the residuals from the regression are white noise.That is, we regress st on (pt-p

*t),

st = α + β(pt - p*t) + εt (6)

and subject the residuals to a stationarity test of white noise.

If the residuals are white noise, then the hypothesis of non-stationarity can be rejected andwe can reject the null hypothesis of no cointegration; a long-run relationship existsbetween exchange rate and relative prices.

In the second step (after establishing a long-run relationship) there may exist an error-correction mechanism (ECM) where short-run dynamics are captured. It takes the form,

∆st = γo + γ1(∆pt - ∆p*t) + γ2εt-1 + µt (7)

where γ2εt-1 is the estimated residuals from equation (6) lagged by one period andµt is the white noise error.

The coefficient γ2 measures the speed of adjustment to the long-run equilibrium. The error-correction model is valid, conditional on the existence of cointegration between exchangerate and relative prices.

Kim (1990) found, using the Engle-Granger method, that in most cases CPI and WPI arecointegrated with the exchange rate at 5% level. Their data are annual figures for Canada,France, Italy, Japan and the UK. Specifically, Abeysinghe & Lee (1992) also foundevidence that the Singapore-US bilateral exchange rate is in agreement with PPP for theperiod of 1975 Quarter 1 to 1993 Quarter 3, when CPI indices are used.

3.2 MONETARY MODELS

The monetary models of exchange rate determination start from the assumption of perfectcapital mobility. PPP and interest rate parity theorems are used in the models to define theequilibrium conditions. Bonds (foreign and domestic) are assumed to be perfectsubstitutes. In this section, we focus on two monetary models, namely the Flexible PriceMonetary Model (FLPM) and the Real Interest Differential Model (RIDM).

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The logarithm of the demand for money is assumed to depend on the logarithm of realincome, y and the logarithm of price level, p and the level of nominal interest rate, r. Anidentical demand for money can also be assumed for the foreign country, where foreignvariables are denoted by asterisks. Monetary equilibria in the domestic and foreign countryis then given by :

mt = pt + φyt - λrt (8)

mt* = pt

* + φyt* - λrt

* (9)

where mt and mt* are the domestic money supply and foreign money supply respectively.

It is also assumed that purchasing power parity holds continuously, this can be expressedas :

st = pt - pt* (10)

where s is the logarithm of exchange rate defined as the domestic currency units per unit offoreign currency.

Another assumption is that foreign and domestic bonds are assumed to be perfectsubstitutes, so that the uncovered interest parity will hold :

E s•t = rt - rt* (11)

where E s•t is the expected rate of depreciation of the domestic currency.

Substituting equations (8) and (9) into (11) gives,

st = (mt - mt*) - φ(yt- yt

*) + λ(rt - rt*) (12)

The nominal interest rate is made up of two components, namely the real interest rate, andthe expected inflation rate, that is :

rt = it + Πte (13)

rt* = it

* + Πte* (14)

where it and it* are the domestic and foreign real interest rate and Πt

e and Πte* are the

expected rates of domestic and foreign inflation respectively. Assuming that the realinterest rates are equalised in both countries, we have

rt - rt* = Πt

e - Πte* (15)

Thus, equation (12) can be rewritten as :

st = (mt - mt*) - φ(yt - yt

*) + λ(Πte - Πt

e*) (16)

The above reduced form equation is the Flexible Price Monetary Model (FLPM). Thecoefficient of the relative money supply is positive and equal to one based on the neutralityof money. The rationale is that for a given percentage increase in the money supply, priceswill increase by the same percentage. If PPP holds continuously, this would mean adepreciation of the domestic currency (st increase) by the same amount, in order to restoreequilibrium.

However, the prediction of a negative coefficient for relative income is opposite to whatthe Mundell-Fleming approach predicts. In the Mundell-Fleming model, a higher real


income will increase imports; this will worsen the trade balance and will require adepreciation of the domestic currency in order to return to equilibrium. In the FLPM, a risein the domestic real income creates an excess demand for the domestic currency. Agentswill then decrease their expenditures in order to increase their real money balances. Thiswill lead to a fall in prices. Then by virtue of PPP, an appreciation of the home currencywill ensure that equilibrium is restored.

Furthermore, an increase in the expected long-run inflation results in agents switchingfrom domestic currency to bonds (both domestic and foreign). Thus the demand fordomestic currency decreases, causing a depreciation of the domestic currency (an increasein st) and thus the coefficient of the relative expected rate of inflation is positive.

Frankel (1979) developed a Real Interest Differential Monetary Model (RIDM)whichincorporates a short-run interest rate to capture liquidity effects. Frankel assumes that theexpected rate of depreciation of the exchange rate is a positive function of the gap betweenthe current exchange rate, st, and the long-run equilibrium rate, s t and the expected long-run inflation differential between the domestic and foreign countries. This yields :

E s• t = - θ (st - s t) + Πte - Πt

e* (17)

where θ is the speed of adjustment to equilibrium. This equation states that the spotexchange rate is expected to return to its long-run equilibrium at the rate of θ. In the long-run, st = s t, then the expected rate of depreciation of the currency will just equal thedifference of domestic to foreign inflation.

Combining equation (11) and (17) gives :

st - s t = −1θ

[ (rt - Πte ) - (rt

* - Πte*) ] (18)

Equation (18) shows that the gap between current real exchange rate and its long-runequilibrium exchange rate is proportional to the real interest differentials between the twocountries. Thus, if the foreign real interest rate is higher than the domestic real interestrate, then there will be capital outflows from domestic bonds to foreign bonds until the realinterest rates are equalised.

The long-run PPP relationship in RIDM is represented by :

s t = p t - p t* (19)

In the long-run, the interest differential must be equal to the long-run expected inflationdifferential,

r t - r t* = Πt

e - Πte* (20)

Thus equation (18) can be rewritten as :

st - s t = −1θ

[ (r t - rt) - (r t* - rt

*) ] (21)

The above equation states that the exchange rate will overshoot its long-run equilibriumrate whenever the relative nominal interest differential increase above their equilibriumlevels.

Combining equation (12), (20) and (21) gives,

140 Cao and Ong

st = (mt - mt *) - φ( y t - y t

*) + λ(Πe - Πte*) (22)

Equation (22) is actually identical to the reduced equation of FLPM , thus the RIDMreduces to a FLPM in the long run.

The short-run dynamics of the RIDM is given by substituting equation (22) into (21)which gives,

st = (mt - mt*) - φ(yt - yt

*) + θ-1(rt - rt*) + (θ-1 + λ)(Πt

e - Πte*)

or

st = α1(mt - mt*) + α2(yt - yt

*) + α3(rt - rt*) + α4(Πt

e - Πte*) (23)

The FLPM is nested within the reduced equation of RIDM in (23); the hypotheses of theFLPM and RIDM are summarised in Table 1.

The signs of the coefficients of α1, α2 and α4 are the same as that for FLPM in Frankel’sRIDM. The α3-coefficient is negative; an increase in the domestic interest rate leads to acapital inflow which increases the demand for the domestic currency and, in turn, bids upthe price of the domestic currency (an appreciation of the domestic currency).

Empirical evidence prior to 1978 supported to both the FLPM and RIDM models. Frankelinitially proxied the expected rate of inflation by a long term interest or consol rate. Hisestimation of RIDM yielded correctly-signed and statistically significant variables for thedeutsmark against the US dollar during the period of July 1974 to February 1978. This ledhim to reject FLPM in favour of RIDM.

Hodrick (1978) and Bilson (1978) also drew supportive empirical evidence for FLPM. Theestimated coefficients are consistent with the FLPM and the regression had reasonable in-sample diagnostics such as a high R2 and a reasonable DW statistic.

However, when the sample period is extended beyond 1978, regressions yieldeddisappointing results which put into question the ability of the monetary models to explainexchange rate movements. Empirical findings by Dornbusch (1980), Frankel (1984) andMacDonald & Taylor (1992a) provide evidence with refutes predictions by the monetarymodels. Their results yielded wrongly signed or insignificant coefficients and theregressions had very poor in-sample performance.

Specifically, Nguyen and Yao (1989) estimated the flexible price and sticky pricemonetary model for Singapore using data from 1977 Quarter 2 to 1987 Quarter 2. Theyfound that coefficients of (m - m*) and (r - r*) were not only wrongly signed, but alsostatistically significant. However, one shortcoming of their study is that they did not checkfor the stationarity of the variables under consideration. Nonstationarity of time series-variables can lead to spurious estimation. Thus, this academic project attempts to rectifythis shortcoming by investigating whether there is a cointegrating relationship among thevariables in the PPP and the monetary model.

Some recent papers (MacDonald & Taylor (1992b, 1994)) have attempted to applycointegration techniques for the estimation of the monetary model. This involves testingfor a long-run relationship between variables in equation (22) and estimating an error-correction form if a cointegrating vector can be found.


Thus, to conclude, both PPP and the Monetary Model are the two most fundamentalmodels of exchange rate determination. Since the exchange rate policy in Singapore isgeared towards maintaining low inflation levels, an empirical examination of the exchangerate with respect to PPP will reveal whether deviations from PPP have occurred during therecent appreciation of the Singapore dollar.

The Monetary Model, on the other hand, traces movements in the exchange rate byexamining monetary variables, with the crucial assumption that PPP is maintainedbetween countries. The question of whether the appreciation of the Singapore-USexchange rate is related to monetary variables (such as money supply) is examined.

4 EXCHANGE RATES AND MONETARY VARIABLES IN SINGAPOREWith complete exchange control liberalisation since 1978, the value of the Singaporedollar has appreciated in terms of US currency. There have been persistent pressures onthe Singapore dollar to appreciate due to compulsory provident fund contributions andconsistent budgetary surpluses (which are sources of liquidity drain from the economy).Thus the MAS has stepped in consistently to constrain the Singapore dollar within itstarget band by selling Singapore dollars and buying US dollars, which reinjects liquidityinto the economy. If there are no such interventions on the part of the MAS, theappreciation of the Singapore dollar would have been greater.

Another interesting feature to note is that the steady long-run appreciation of the Singaporedollar displays no wide fluctuations. This implies that the MAS has monitored movementsof the exchange rate closely so as to avoid excessive fluctuation which may prove to bedetrimental to export performance.

According to Classen (1992), the period of 1981 to 1985 was one where the Singaporedollar stabilised vis-à-vis the US dollar. Classen argued that during this period, the MASswitched from a ‘multicurrency peg’ to a US-dollar peg. This arose out of the desire forSingapore to maintain a strong domestic currency so as to enhance its position as aninternational financial centre. This ‘real appreciation’ of the Singapore dollar is one of thefactors that contributed to the recession in 1985, according to Classen.

The depreciation of the Singapore dollar to the US dollar in 1985 is due to the recessionthat plagued the economy then. In 1985, the Gross domestic Product fell 1.8 per cent(MAS Annual Report 1985/86) due to a decline in economic activities. The economypicked up in 1986 and the Singapore dollar recovered slightly higher against the US dollar.Since the recession in 1985, the Singapore dollar continued to appreciate gradually againstthe US dollar.

Figure 1 shows the movement of the Singapore dollar relative to the US dollar as well asthe price ratio (CPISingapore / CPIUS) for the period 1978Q1 to 1993Q4. Both series move inthe direction predicted by PPP. However, there are more fluctuations in the bilateralexchange rate than with the price ratio.

Figure 2 shows the trend of the bilateral exchange rate and that of the income ratio (GDPSingapore/ GDP US). Both series have moved in opposite directions with the exchangerate decreasing (i.e. Singapore dollar appreciating) and the income ratio increasing. InFigure 3, plots of the bilateral exchange rate and the relative interest rate display noobservable common pattern.

142 Cao and Ong

The trends of the Singapore-US dollar exchange rate and money supply (M2) as shown inFigure 4 seem to be contrary to what the monetary model predicts with each of the seriesmoving in opposite directions.

In the next section, regressions will be run using these data series to provide a moredetailed analysis and at the same examine the relevance of both PPP and the monetarymodel on the Singapore to the US bilateral exchange rate.

5 TESTS OF PPP AND MONETARY MODELSThe quarterly data for this empirical study is extracted from the International FinancialStatistics (IFS) tapes for the period of 1978Q1 to 1993Q4. There are a total of 64 datapoints. The availability of the length of the time series allows us to better investigate thetwo models in a long-run setting. A shorter time series may cause us to reject PPP, notbecause it is invalid but simply because that the exchange rate has not returned to the PPPequilibrium within the arbitrarily-chosen time frame.

Exchange rates are period averages of market exchange rates. The consumer price indicesof both Singapore and the US (with base year 1990) are chosen to represent the generalprice level. CPI is chosen because Abeysinghe & Lee (1992) conclude in their study thatpolicy-makers in Singapore target exchange rate movements using CPI.

Both M1 and M2 were experimented with in the original regressions, however, it wasfound that M2 yields better and more significant results than M2. Therefore, only theregressions with M2 as the proxy for money supply are represented. Real GDP forSingapore and the US are chosen as proxies for relative income.

The 3 months time deposit rate and the 3 months US dollar London offer rate are chosenrespectively to represent the short-term interest rates in Singapore and the US. The proxyused for the expected long term differential inflation rate between the two country is theone period lagged inflation differential between Singapore and the US.

Before testing for a long-run relationship between variables, it is necessary to establish thatthe variables are of the same order of integration. In general, if time series are of differentorder of integration, there cannot exist a long-run relationship (i.e. there is nocointegration). In order to test the order of integration, the DF test for unit roots is used totest for stationarity; results are presented in Table 2.

Table 2 indicates that all series are I(1) processes. First differences of all variables (asshown on Table 2) have negative and significant DF statistics. Next, we test forcointegration among variables for absolute PPP, relative PPP and the monetary model.

Since the RIDM incorporates short-run influences (via the short-term interest rate), onlyFLPM can be tested in a long-run setting. To test the null hypothesis of no cointegration,the Engle and Granger two-step methodology requires that the standard tests of unit roothypothesis be applied to residuals of the cointegrating regression. The is because, underthe null hypothesis of no integration, all linear combinations of the integrated series willhave a unit root. While under the alternative hypothesis of cointegration, the residuals ofthe cointegrating regression will be stationary. Thus, cointegration tests are performed onabsolute PPP (equation 6), relative PPP (equation 7) and the FLPM (equation 22) asspecified in Section 3; the corresponding econometric models are as follows:

st = α1 + α2(pt - p*t) + µt (24)


∆st = β1 + β2(∆pt - ∆p*t) + εt (25)

st = γ1 + γ2(mt - m*t) + γ3(yt -y

*t) + γ4(∏

et - ∏

et*) + ηt (26)

Cointegration requires that the residuals in equations (24), (25) and (26) be stationary. Thecointegrating regression estimates and test statistics are reported in Table 3.

Evidence from Table 3 supports cointegration for the relative PPP and FLPM, but not forabsolute PPP. This is puzzling as since both st and (pt - p

*t) are integrated to order one, it

would normally imply that the error term in equation (24) is white noise. Thus, a long-runrelationship between the exchange rate and relative prices cannot be concluded here.

However, the hypotheses of unit roots are rejected for the relative PPP and FLPM. Thecointegrating regressions yield negative and significant DF test statistics at 10% ofsignificance. Thus, it seems to imply that relative PPP holds in the long run and that thereis a long-run relationship between variables of the FLPM model. From Table 3, estimationof both equations (25) and (26) yielded low DW statistics, implying that the two modelsdid not capture the short-run fluctuations well. Although the coefficients of the relativePPP are correctly signed, the coefficients for (mt - m

*t) and (yt - y

*t) of the FLPM model

are wrongly signed and significant.

Since equations (25) and (26) are cointegrated, error-correction models for the relativePPP and FLMP model can be developed to describe the short-run dynamics. The error-correction models (ECM) for both the relative PPP and FLPM models are shown in Table4.

The error-correction term, RESt-1, in both (I) and (II) of Table 4 is statistically significantand represents the short-run adjustment mechanism. In the case of the ECM for relativePPP, it is negatively signed and quite substantial (-0.84373) while that for the monetarymodel is also negatively signed, however, smaller in magnitude (-0.25989). The R2 of theECMs are high (0.9706 and 0.9732 for the relative PPP and monetary modelsrespectively). The estimated DW statistic in the ECM for relative PPP is 1.8084. Fromthe Durbin-Watson Table, the critical values for 65 observations (actual data series are 64observations, however the table has only values for 65 observations, thus critical values for65 observations are used as an approximation) and 2 explanatory variables are dL = 1.377and dU = 1.500 at the 1 percent level of significance, thus the estimated value of 1.8084lies above 1.500 and we accept the null hypothesis of no positive autocorrelation.

Similarly, the DW statistics for the ECM of the Monetary Model is 1.7664, while thecritical values are dL = 1.315 and dU = 1.568, thus we can also accept the null hypothesisthat there is no positive autocorrection. The DW statistics improved substantially for theECMs as compared to the initial regressions as shown in Table 3.

Data series for period of 1978 to 1993 do not seem to correspond to the predictions of theFLPM model. It yielded negatively signed and significant coefficients for the relativemoney supplies and relative income in the OLS estimation (See Table 3). Even for theECM in Table 4, the FLPM does not perform well. The coefficient of ∆(yt - y

*t) is wrongly

signed and marginally significant at the 10% level (critical value = 1.671 for 64 d.o.f.).Although the coefficient of ∆(∏e

t -∏et*) is wrongly signed in the ECM, it is not

statistically significant.

144 Cao and Ong

One possible explanation for the negatively signed relative money supply is that the moneysupply in Singapore may be endogenously determined. This is the case when thegovernment decides to target the exchange rate; they lose control of the money supply. Inthe case of Singapore, where the exchange rate is a target variable, CPF contributions andbudgetary surplus drain liquidity from the system. Thus the MAS has to intervene in themoney market by buying US dollars and selling Singapore dollars to inject liquidity backinto the system. As a result, the MAS has lost control of the money supply and it isendogenous. If this is the case, then estimation would have to be done by method ofinstrumental variables in order to account for endogeniety.

Another consideration could be that relaxation of the constraint of unitary elasticity of themoney differential combined with equal and opposite signed elasticities on real outputmay improve the estimation results. However, empirical evidence on this is not supportive(see Radaelli (1988)). Another possible reason is that there may be financial innovationsthat shift the demand of money during the period of 1978 to 1993, resulting in unstabledemand for money which violates the implicit assumption of stable money demand in themonetary model.

The monetary model is unable to explain the appreciation of the Singapore dollar. Thismay be due to the fact that in a country with a relatively low inflation such as Singapore,non-transitory real factors, such as real economic growth and productivity growth tend todominate exchange rate changes, rather than monetary factors. Thus, it would seem thatalthough all variables in the monetary model are cointegrated with the exchange rate (i.e.there exists some long-run relationship), its relationship may not as simple as the monetarymodel suggests.

On the other hand, the simple relative PPP yielded more reasonable estimates.Cointegration confirmed a long-run relationship between the variables in relative PPP. Notonly are estimated coefficients correctly signed but they are also significant with a high R2.The ECM of the relative PPP also yielded good results. The EC term is both correctlysigned as well as statistically significant. Thus, the Singapore to US-dollar exchange rate isin agreement with the relative version of PPP. This also suggests that the movement of theSingapore to US-dollar exchange has not deviated from PPP equilibrium.

6 CONCLUSIONSThe dismal empirical findings for the monetary model for Singapore is hardly surprising asmany authors have arrived at similar results for data series from 1978 onwards. This paperconfirms that the monetary model does not quite explain the movements of the Singaporedollar - US dollar exchange rate from 1978 to 1993.

The empirical results cast doubt on the validity of monetary model as a model of exchangerate determination. However, this is not the final word. A recent article by MacDonald andTaylor (1994) shows that the unrestricted monetary model is a valid long-run equilibriumcondition and allowing, for short-run dynamics, it out-performs a random walk inforecasting. In their paper, they use the multivariate cointegration technique by Johansen(1988) which they consider superior to the Engle-Granger’s two-steps methodology. Thusit seems that with proper specification and estimation methods, the monetary model maynot be as bad as widely thought.

With more innovation and creativity in financial products over the past few years, agentsmay no longer view all non-money assets as perfect substitutes. Thus, another extension


may be that a hybrid of the monetary and portfolio approach (which is beyond thecoverage of this paper) could be more appropriate. Nguyen and Yao (1989) estimated acomposite model (synthesised model of monetary approach and portfolio balanceapproach) for Singapore and found satisfactory estimates and out-of-sample forecast.However, their conclusion that official intervention played a minor role is doubtful.

The monetary model of exchange rate determination is a theory of long-run equilibriumwhich is most appropriate for economies suffering from major monetary shocks, thus itmay not be a good theory to apply in the case of Singapore.

Furthermore, the uniqueness of the Singapore economy (with a liquidity drain from thebanking system) requires reinjection of liquidity into the system in order to avoid a sharpappreciation of the Singapore dollar. The buying of foreign reserves by the authorities hasthe effect of increasing the money supply and foreign reserves in Singapore. This may helpto explain why the monetary model fails to account for the negative relationship betweenrelative money supplies and the exchange rate.

Lastly, since the 1970s, both countries have experienced economic growth (especially inthe case of Singapore), however the naive monetary models (FLPM and RIDM) have notbeen factored into this consideration. This is one limitation of the study. Recently, manyother monetary models (e.g. Buiter-Miller model) have been developed to take intoaccount of economic growth but also that of trended PPP (Yip (1994)).

Our results confirm that relative PPP holds in the long-run for the Singapore - US-dollarexchange rate. The ECM of relative PPP is also able to explain short-run dynamicsreasonably well. This shows that the managed float of the Singapore dollar has not createda deviation from the PPP path of exchange rate.

Thus, to conclude, empirical support for relative PPP for the Singapore - US bilateralexchange rate is found. Although the monetary model fared badly in this empirical study,it should not be dismissed readily and warrants further research.

146 Cao and Ong

REFERENCES

Abeysinghe, Tilak and Lee Kok Hong (1992), “Singapore Strong Dollar Policy andPurchasing Power Parity”, Singapore Economic Review, Vol 37, No. 1, April, pp 70 -79

Balassa, B. (1964), “The Purchasing Power Parity : A Reappraisal”, Journal of PoliticalEconomy, Vol 72, pp 584 - 596

Bahmani-Oskoee, M. (1993), The Purchasing Power Parity Based on Effective ExchangeRate and Cointegration : 25 LDCs’ Experience with its Absolute Formulation, WorldDevelopment, Vol 21, No. 6, pp 1023 -1031

Bilson, J.F.O. (1978), “Rational Expectations and the Exchange Rate”, in Frankel, J.A.and Harry G. J. (eds), The Economics of Exchange Rates, Addison-Wesley

Cassel, Gustav (1916), “The Present Situation of the Foreign Exchange”, EconomicJournal, March

Cassel, Gustav (1918), “Abnormal Deviations in International Exchanges”, EconomicJournal, December

Cassel, Gustav (1919), “The Depreciation of the German Mark”, Economic Journal,December

Cassel, Gustav (1922), Money and Foreign Exchange After 1914, London, Macmillian

Classen, Emil-Maria (1992), Financial Liberalisation and its Impact on DomesticStabilisation Policies : Singapore and Malaysia, Institute of Southeast Asian Studies

Dornbusch, R. (1980), “Exchange Rate Dynamics : where do we stand?”, BrookingsPapers on Economic Activity, pp 143-155

Frankel, J.A. (1979), “On the mark: a theory of floating exchange rate based on realinterest differentials”, American Economic Review, May, pp 610 - 622

Frankel, J.A. (1984), “Tests of monetary and portfolio balance models of exchange ratedetermination”, in Bilson, J.F.O. and R.C. Marston (eds), Exchange Rate Theory andPractice, Chicago: University of Chicago Press

Hodrick, Robert J. (1978), “An Empirical Analysis of the Monetary Approach toDetermination of the Exchange rate”, in Frankel, J.A. and Harry G. Johnson (eds), TheEconomics of Exchange Rates, Addison-Wesley

Johansen, Soren (1988), “Statistical Analysis of Cointegration Vectors”, Journal ofEconomic Dynamics and Control, June/September, pp 231 -254

Kim, Y. (1990), “Purchasing Power Parity in the Long-run : A Cointegration Approach”,Journal of Money, Credit and Banking, pp 491 - 503

Lee, Sheng-Yi (1990), The Monetary and Banking Development of Singapore andMalaysia, 3rd Ed., Singapore University Press

Lim and Associates (1988), Policy Options for the Singapore Economy, Singapore:McGraw-Hill Book Co.

MAS Annual Reports, various issues

MacDonald, R. and Taylor M.P.(1992a), “Exchange Rate Economics : A Survey”,International Monetary Fund Staff Papers, March, pp 1 -57


MacDonald, R. and Taylor M.P. (1992b), “The Monetary Model of Exchange Rate :Long-run Relationship and Short-run Dynamics”, Discussion Papers in FinancialMarkets, No. 6, March, University of Dundee

MacDonald, R. and Taylor M.P. (1994), “The monetary model of the exchange rate: longrun relationships, short-run dynamics and how to beat a random walk”, Journal ofInternational Finance, 13(3), pp 276 -290

McNorm, R. and M.S. Wallace (1989), “International Price Levels, Purchasing PowerParity and Co-integration : A Tests of 4 High-inflation Economies”, Journal ofInternational Money and Finance, Vol 8, pp 533 - 545

Min, Tang and Ronald Q. Buitiong (1994), Purchasing Power Parity in Asia DevelopingCountries : A Cointegration Test, Asian Development Bank, April

Nguyen, Duc-Tho and Yao Chye Chiang (1989), Exchange Rate Determination : The Caseof Singapore, University of Adelaide

Pentocost, Eric J. (1993), Exchange Rate Dynamics : A Modern Analysis of Exchange RateTheory and Evidence, Cambridge : University Press

Radaelli, G. (1988), “Testable Restriction and Forecasting Performance of ExchangeDetermination Models”, Chase Manhatten Bank, Working Paper in FinancialEconomics, No.4

Teh, Kok Peng and Tharman Shanmugaratnam (1992), “ Exchange Rate Policy :Philosophy and Conduct over the Past Decade”, in Low, Linda and Toh Mun Peng(eds), Public Policies in Singapore: Changes in the 1980s and Future Signposts,Times Academic Press

Yip, S. L. Paul; (1994), “The Singapore Dollar: Where to we stand ?,” working paper,Nanyang Technological University

148 Cao and Ong

TABLE 1FLEXIBLE PRICE MONETARY MODEL (FLPM) AND

REAL INTEREST DIFFERENTIAL MONETARY MODEL (RIDM)HYPOTHESES

Model α1 α2 α3 α4

FLPM + - 0 +RIDM + - - +

TABLE 2TESTS FOR UNIT ROOTS

τm

Variables I(0) I(1)st 0.008402 -7.6105*

pt - p*t -0.623272 -6.5073*

mt - m*t

-0.91193 -5.8844*

yt - y*t

1.5864 -9.6299*

rt - r*t

-1.1458 -8.4487*

∏er - ∏

et* -1.6563 -6.0635*

Note : τm is the test statistic for a constant mean.

* indicates that statistic is statistically significant at 10% level (critical value is -2.60).


TABLE 3TESTS OF COINTEGRATION BETWEEN THE EXCHANGE RATE AND THE

FUNDAMENTAL VARIABLES

OLS Estimation of

st = α1 + α2(pt - p*t) + µt

st = 0.60530 + 0.75971(pt - p*t) + µt

(49.877) (10.380)

R2 = 0.6347

DW = 0.0997

DF Stat = -1.3963

OLS estimation of

∆st = β1 + β2(∆pt - ∆p*t) + εt

∆st = 0.0078706 + 2.1676(∆pt - ∆p*t)

(2.3588) (31.111) + εt

R2 = 0.9398

DW = 1.6658

DF Stat = -6.6670*

OLS Estimation

st = γ1 + γ2(mt - m*t) + γ3(yt -y

*t) + γ4(rt - r

*t) + γ5(∏

et - ∏

et*) + ηt

st = -0.63039(mt - m*t) + 0.33923(yt -y

*t)

(-23.008) (17.522) + 0.0042068(∏e

t - ∏et*) + ηt

(2.0388)R2 = 0.9431

DW = 0.8155

DF Stat = -3.9089*

Note: The t-statistics are in parentheses

*indicates that the unit root hypothesis rejected at 10% significance level (critical value = -2.60)

150 Cao and Ong

TABLE 4ERROR-CORRECTION MODELS FOR RELATIVE PPP AND

MONETARY APPROACH

(I) ECM for Relative PPP Cointegrating Vector : ∆st - [ 0.0078706 + 2.1676 (∆pt - ∆p*

t)] = RESt

ECM : ∆2st = 2.1324∆(∆pt - ∆p*

t) - 0.84373 RESt-1 + µt

(44.611) (-6.6872 ) R2 = 0.9706 DW = 1.8084(II) ECM for FLPM Model Cointegrating Vector : st -[-0.63039(mt - m

*t) + 0.33923(yt -y

*t) + 0.0042068(∏e

t - ∏et*)] = RESt

ECM : ∆st = -0.0025370 - 0.30030∆(mt - m

*t) + 0.092630∆(yt - y

*t)

(-1.0879) (-4.0283) (1.6864) - 0.0003526∆(∏e

t -∏et*) - 0.25989 RESt-1 + µt

(-0.15899) (-2.6895) R2 = 0.9732 DW = 1.7664

Note: The t-ratios are in parentheses

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Documents

PPP and the Monetary Model of Exchange-Rate …PPP and the Monetary Model of Exchange-Rate Determination:... 133 However, the float of the Singapore dollar since 1973 has been in a