Exchange Rate Regimes:Exchange Rate Regimes:What Can We Learn from What Can We Learn from

Hong Kong and PhilippinesHong Kong and Philippines

Paul D. McNelisPaul D. McNelisFordham UniversityFordham University

April 2009April 2009

RelevanceRelevance

Bangko Sentral ng Pilipinas is now rated in the Bangko Sentral ng Pilipinas is now rated in the top ten of central banks world wide for top ten of central banks world wide for transparencetransparence

Since the Reform Act of 1994 BSP shifted from Since the Reform Act of 1994 BSP shifted from a backward-looking monetary-targeting scheme a backward-looking monetary-targeting scheme to a forward-looking inflation-targeting regime.to a forward-looking inflation-targeting regime.

Hong Kong experienced acute deflation Hong Kong experienced acute deflation between 1998 and 2004. Yet it maintained its between 1998 and 2004. Yet it maintained its currency board or hard bet to the dollar. currency board or hard bet to the dollar. Should HK have changed after the onset of the Should HK have changed after the onset of the Asian crisis?Asian crisis?

The DataThe Data

Macro Time Series, Macro Time Series,

Philippines, 1995-2008Philippines, 1995-2008

Hong Kong, 1984-2008Hong Kong, 1984-2008

Interest Rates, Inflation and Terms of Trade in Interest Rates, Inflation and Terms of Trade in PhilippinesPhilippines

GDP and ConsumptionGDP and Consumption

Exports and Imports in Exports and Imports in PhilippinesPhilippines

Spending in PhilippinesSpending in Philippines

Financial Sector in Financial Sector in PhilippinesPhilippines

Hong Kong Inflation and Hong Kong Inflation and GrowthGrowth

Deposits and Loans in HKDeposits and Loans in HK

HK: Index of OpennessHK: Index of Openness

HK Terms of TradeHK Terms of Trade

Two QuestionsTwo Questions

When the BSP shifted policy toward When the BSP shifted policy toward inflation targeting, did it make a big inflation targeting, did it make a big difference, in terms of economic difference, in terms of economic structural change and welfare?structural change and welfare?

Would Hong Kong have done better if Would Hong Kong have done better if the HKMA shifted to inflation the HKMA shifted to inflation targeting after the Asian crisis in targeting after the Asian crisis in 1998?1998?

Mythology: Bayesian DSGE Mythology: Bayesian DSGE ModelModel

DDynamic: ynamic: explains how the economy evolves over explains how the economy evolves over time;time;

SStochastic: tochastic: embeds theembeds the random or unknown random or unknown shocks (e.g., technological change, oil price shocks (e.g., technological change, oil price volatility and uncertainty in macroeconomic volatility and uncertainty in macroeconomic policy making) that hit the economy.policy making) that hit the economy.

GGeneral eneral EEquilibrium framework: quilibrium framework: depicts the depicts the macro economy as the sum of individual choices macro economy as the sum of individual choices and decisions made by firms, households, the and decisions made by firms, households, the government, and the central bank, according to government, and the central bank, according to their own preferences and views about the future. their own preferences and views about the future.

Why?Why?

Complements rather than replaces existing models Complements rather than replaces existing models ‘‘thick’ models because there is no one true model thick’ models because there is no one true model

The general equilibrium framework tends to reduce The general equilibrium framework tends to reduce inconsistencies and forces the modelers and inconsistencies and forces the modelers and policymakers to think of economic linkages in a policymakers to think of economic linkages in a disciplined manner.disciplined manner. The micro-foundations of DSGE models make them The micro-foundations of DSGE models make them

more suitable for policy evaluation because the more suitable for policy evaluation because the relationships embodied do not change with changes in relationships embodied do not change with changes in the policy environment. the policy environment.

Key benefit: evaluation of welfare effectsKey benefit: evaluation of welfare effects

Why Bayesian DSGE?Why Bayesian DSGE? Since the late 1970’s we have shifted to Bayesian Since the late 1970’s we have shifted to Bayesian

Macro-econometrics.Macro-econometrics. Equivalent to moving from the Wright Brothers to Equivalent to moving from the Wright Brothers to

A380 fly bye wire jets in 30 years.A380 fly bye wire jets in 30 years.

There have been big structural shifts that weaken There have been big structural shifts that weaken the usefulness of historical time series. We have the usefulness of historical time series. We have less data that we think, even in developed less data that we think, even in developed countries like the USA. countries like the USA.

In short, all of us have to work with limited data In short, all of us have to work with limited data sets.sets.

Using classical statistics, no scientific researcher Using classical statistics, no scientific researcher would claim any evidence based on tests with 40 or would claim any evidence based on tests with 40 or 100 observations. 100 observations.

Recognizes that we only have vague understanding Recognizes that we only have vague understanding of true relationship among economic variables.of true relationship among economic variables.

The only ‘truth’ is what we observeThe only ‘truth’ is what we observe Makes use of our beliefs (“subjective priors”) Makes use of our beliefs (“subjective priors”)

and allows the data to modify our priors and allows the data to modify our priors (learning process)(learning process)

More Reasons for Bayesian More Reasons for Bayesian MethodsMethods

Truth is, Bayesian macro-econometrics is easier. Truth is, Bayesian macro-econometrics is easier. Easier to integrate a likelihood function numerically than Easier to integrate a likelihood function numerically than

it is to maximize it—complexity, curse of dimensionality.it is to maximize it—complexity, curse of dimensionality. Bayesian inference is a way of thinking, not a basket of Bayesian inference is a way of thinking, not a basket of

methods (Sims): we go directly to the data, apply Bayes’ methods (Sims): we go directly to the data, apply Bayes’ theorem and learn from it.theorem and learn from it.

Frequentist statements are beautiful but inconsequential Frequentist statements are beautiful but inconsequential for decision-makers: who cares about a 95% confidence for decision-makers: who cares about a 95% confidence intervalinterval

Not making use of prior information is an unforgivable sin Not making use of prior information is an unforgivable sin of omission.of omission.

Real life is full of bad or incomplete data—we have to Real life is full of bad or incomplete data—we have to make the best out of bad situations.make the best out of bad situations.

Classical methods have a harder time jumping from point Classical methods have a harder time jumping from point estimates to whole distributions of policy-relevant estimates to whole distributions of policy-relevant objects.objects.

We search for “pseudo-true parameter values”: how to We search for “pseudo-true parameter values”: how to use a model as a language to express regular features of use a model as a language to express regular features of data, to tell powerful economic histories and exert data, to tell powerful economic histories and exert control over outcomes of interest.control over outcomes of interest.

Flow Chart of Bayesian Flow Chart of Bayesian MethodMethod

Summary for Using Bayesian Summary for Using Bayesian MethodMethod

Structure of Model:Structure of Model:Conceptual Model (CM)Conceptual Model (CM)

Agents and Decision MakersAgents and Decision Makers

Risks in the Conceptual Risks in the Conceptual ModelModel

Actors: Household, Firms, Actors: Household, Firms, Central Bank, Banks, Fiscal Central Bank, Banks, Fiscal

AuthorityAuthority

Bayesian Bayesian Macroeconometrics:Macroeconometrics:Philippines and HKPhilippines and HK

Adjusting Conceptual Model Adjusting Conceptual Model by the Databy the Data

Philippines Structural Parameters and VolatilitiesPhilippines Structural Parameters and Volatilities

Philippines: Variance Decomposition of InflationPhilippines: Variance Decomposition of Inflation

Counterfactual Policy Simulation for PhilippinesCounterfactual Policy Simulation for Philippines

Hong Kong: Structural Parameters and VolatilitiesHong Kong: Structural Parameters and Volatilities

Variance Decomposition for Variance Decomposition for Hong KongHong Kong

HK: Counterfactual Inflation HK: Counterfactual Inflation TargetingTargeting

Counterfactual Inflation Counterfactual Inflation Volatility in HKVolatility in HK

HK: Interest VolatilityHK: Interest Volatility

ConclusionsConclusions

Welfare improved by quite a bit when the BSP Welfare improved by quite a bit when the BSP shifted from a backward-looking money targeting shifted from a backward-looking money targeting regime to a forward-looking inflation-targeting regime to a forward-looking inflation-targeting regimeregime

Hong Kong would not have been better off if the Hong Kong would not have been better off if the HKMA shifted from its currency board to inflation-HKMA shifted from its currency board to inflation-targeting in the wake of the Asian crisis or targeting in the wake of the Asian crisis or deflation.deflation.

Both countries have quite a bit of price flexibility.Both countries have quite a bit of price flexibility. For HK, foreign interest rates are very important, For HK, foreign interest rates are very important,

for Philippines, exports and terms of trade more for Philippines, exports and terms of trade more important.important.