The monetary model in the presence of I(2) components: long-run relationships, short-run dynamics and forecasting of the Greek drachma

This paper re-examines the long-run properties of the monetary exchange rat e model using data for the drachma-dollar and drachma-mark exchange rates u nder the hypothesis that the system contains variables that are I(2). Using the recent I(2) test by Paruolo (On the determination of integration indic es in I(2) systems. J. Economet. 72 (1996) 313-356) to examine the presence of I(2) and I(1) components in a multivariate context we find that the sys tem contains two I(2) variables in both cases and this finding is reconfirm ed by the estimated roots of the companion matrix (Do purchasing power pari ty and uncovered interest rate parity hold in the long-run? An example of l ikelihood inference in a multivariate time-series model. Juselius, J. Econo met, 69 (1995) 211-240). The I(2) component led to the transformation of th e estimated model by imposing long-run but not short-run proportionality be tween domestic and foreign money. Two statistically significant cointegatin g vectors were found and, by imposing linear restrictions on each vector as suggested by Johansen and Juselius (Identification of the long-run and the short-run structure: an applicaion to the ISLM model. J. Economet. 63 (199 4) 7-36) and Johansen (Identifying restrictions of linear equations with ap plications to simultaneous equations and cointegration. J. Economet. 69 (19 95b) 111-132), the order and rank conditions for identification are satisfi ed, but the test for overidentifying restrictions was not significant only for the case of the drachma/mark rate. The main findings suggest that we re ject the forward-looking version of the monetary model for the drachma/doll ar case but not when the drachma/mark rate is used, a result that is attrib uted to the monetary and exchange rate policy followed by the Greek authori ties since Greece's joining of the European Union. Furthermore, we test for parameter stability using the tests developed by Hansen and Johansen (Recu rsive estimation in cointegrated VAR-models. Working paper (1993) Universit y of Copenhagen) and it is shown that the dimension of the cointegration ra nk is sample independent while the estimated coefficients do not exhibit in stabilities in recursive estimations. Finally, it is shown that the monetar y model outperforms the random walk model in an out-of-sample forecasting c ontest. (C) 2000 Elsevier Science Ltd. All rights reserved. JEL classificat ion: F31: F33; C32; C51; C52.