International Macroeconomics and
             Finance: Theory and Empirical Methods
                     Nelson C. Mark
                     December 2000
                 forthcoming, Blackwell Publishers
                                      i
        To Shirley, Laurie, and Lesli
              ii
              Preface
              This book grew out of my lecture notes for a graduate course in in-
              ternational macroeconomics and finance that I teach at the Ohio State
              University. The book is targeted towards second year graduate stu-
              dents in a Ph.D. program. The material is accessible to those who have
              completed core courses in statistics, econometrics, and macroeconomic
              theory typically taken in the first year of graduate study.
                These days, there is a high level of interaction between empirical
              and theoretical research. This book reflects this healthy development
              by integrating both theoretical and empirical issues. The theory is in-
              troduced by developing the canonical model in a topic area and then its
              predictions are evaluated quantitatively. Both the calibration method
              and standard econometric methods are covered. In many of the empir-
              ical applications, I have updated the data sets from the original studies
              and have re-done the calculations using the Gauss programming lan-
              guage. The data and Gauss programs will be available for downloading
              from my website: www.econ.ohio-state.edu/Mark.
                There are several di↵erent ‘camps’ in international macroeconomics
              and finance. One of the major divisions is between the use of ad hoc
              and optimizing models. The academic research frontier stresses the
              theoretical rigor and internal consistency of fully articulated general
              equilibrium models with optimizing agents. However, the ad hoc mod-
              els that predate optimizing models are still used in policy analysis and
              evidently still have something useful to say. The book strikes a middle
              ground by providing coverage of both types of models.
                Someoftheotherdivisionsinthefieldareflexiblepriceversussticky
              price models, rationality versus irrationality, and calibration versus sta-
              tistical inference. The book gives consideration to each of these ‘mini
              debates.’ Each approach has its good points and its bad points. Al-
              though many people feel firmly about the particular way that research
              in the field should be done, I believe that beginning students should
              see a balanced treatment of the di↵erent views.
                Here’s a brief outline of what is to come. Chapter 1 derives some
              basic relations and gives some institutional background on international
              financial markets, national income and balance of payments accounts,
              and central bank operations.
                                      iii
          Chapter 2 collects many of the time-series techniques that we draw
        upon. It is not necessary work through this chapter carefully in the
        first reading. I would suggest that you skim the chapter and make
        note of the contents, then refer back to the relevant sections when the
        need arises. This chapter keeps the book reasonably self-contained and
        provides an ecient reference with uniform notation.
          Manydi↵erent time-series techniques have been implemented in the
        literature and treatments of the various methods are scattered across
        di↵erent textbooks and journal articles. It would be really unkind to
        send you to multiple outside sources and require you to invest in new
        notation to acquire the background on these techniques. Such a strat-
        egy seems to me expensive in time and money. While this material
        is not central to international macroeconomics and finance, I was con-
        vinced not to place this stu↵ in an appendix by feedback from my own
        students. They liked having this material early on for three reasons.
        First, they said that people often don’t read appendices; second, they
        said that they liked seeing an econometric roadmap of what was to
        come; and third, they said that in terms of reference, it is easier to flip
        pages towards the front of a book than it is to flip to the end.
          Moving on, Chapters 3 through 5 cover ‘flexible price’ models. We
        beginwiththeadhocmonetarymodelandprogresstodynamicequilib-
        rium models with optimizing agents. These models o↵er limited scope
        for policy interventions because they are set in a perfect world with no
        market imperfections and no nominal rigidities. However, they serve as
        ausefulbenchmarkagainstwhichtomeasurerefinementsandprogress.
          The next two chapters are devoted to understanding two anomalies
        in international macroeconomics and finance. Chapters 6 covers devia-
        tions from uncovered interest parity (a.k.a. the forward-premium bias),
        and Chapter 7 covers deviations from purchasing-power parity. Both
        topics have been the focus of a tremendous amount of empirical work.
          Chapters 8 and 9 cover ‘sticky-price’ models. Again, we begin with
        ad hoc versions, this time the Mundell–Fleming model, then progress
        to dynamic equilibrium models with optimizing agents. The models
        in these chapters do suggest positive roles for policy interventions be-
        cause they are set in imperfectly competitive environments with nomi-
        nal rigidities.
          Chapter 10 covers the analysis of exchange rates under target zones.