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Empirical Economics

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07-01-2016

Fluctuations of the real exchange rate, real interest rates, and the dynamics of the price of gold in a small open economy

Authors: Christian Pierdzioch, Marian Risse, Sebastian Rohloff

Published in: Empirical Economics | Issue 4/2016

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Abstract

Economic theory predicts that, in a small open economy, the dynamics of the real price of a commodity should be linked to a large-country real interest rate and fluctuations of the real exchange rate. Using data for Australia, we test this prediction using an out-of-sample forecasting experiment. We evaluate the economic value-added of out-of-sample forecasts by means of a behavioral approach that takes into account that a forecaster may have an asymmetric loss function.

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For earlier research on the real interest rate as a determinant of the price of gold, see Diba and Grossman (1984), Barsky and Summers (1988), and Pindyck and Rotemberg (1990).

Other recent applications of the forecasting approach include Alcock and Gray (2005), Hartmann et al. (2008), and Sarno and Valente (2009). Although we use the forecasting approach also used by Pierdzioch et al. (2014a, b), it should be emphasized that their results cannot be directly compared with our results. First, they study nominal gold-price fluctuations from a US-based perspective. We, in contrast, study fluctuations of the real gold price using data for Australia. Second, sample periods differ across studies. For example, Pierdzioch et al. (2014a) study monthly data for the sample period 1987\(-\)2012. We study quarterly data for the sample period 1977\(-\)2014.

An increase in the foreign real interest rate should result in a higher expected rate of change of the gold price. Hence, as in the model studied by Frankel (2008, 2014), a higher foreign real interest rate should result in a lower level of the real gold price.

The forecasting models always include a constant.

If more than one model maximizes the proportion of correct in-sample forecasts, we use the ACD model-selection criterion to select a single forecasting model.

When computing the ACD criterion, we use a logistic function to transform the ACD model-selection criterion so as to decrease (increase) the weight attached to forecasts implied by forecasting models with a low (high) ACD model-selection criterion.

The behavioral approach could easily be extended to study some other widely studied loss function like the linex loss function. We specify the criterion in terms of the loss function studied by Elliott et al. (2005, 2008) because, in recent research on gold-price fluctuations, Pierdzioch et al. (2014b) use such a specification.

See http://research.stlouisfed.org/fred2/. In case data are available at a higher than quarterly frequency, we use quarterly averages. We use revised macro data because the purpose of our forecasting experiment is to test the model of gold-price determination outlined in Sect. 2. Lettau and Ludvigson (2009, pp. 647–648) argue that revised macro data should be used to study equilibrium asset-pricing models, while real-time macro data should be used to track a practitioner’s real-time information set.

All graphs and computations were coded up using the free R programming environment (R Core Team 2015).

Results for other training periods (not reported in Table 2, but available from the authors upon request) are similar. Because the choice of the training period is somewhat arbitrary, we shall present in Sect. 4.3 results for alternative training periods.

We use the length of the training period to fix the length of the rolling-estimation window. Because a rolling-estimation window implies that the number of data used for estimation is relatively small given that we study quarterly data, we present in Fig. 5 only results for a forecast-averaging criterion and window lengths of 15 and 20 years.

For an extension that accounts for potential nonlinearities triggered by financial crises, see Hartmann et al. (2008). See Minford and Srinivasan (2008) for an analysis of the observational equivalence of nonlinearities in the data-generating process and an asymmetric loss function in the context of monetary policy.

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Title: Fluctuations of the real exchange rate, real interest rates, and the dynamics of the price of gold in a small open economy
Authors: Christian Pierdzioch
Marian Risse
Sebastian Rohloff
Publication date: 07-01-2016
Publisher: Springer Berlin Heidelberg
Published in: Empirical Economics / Issue 4/2016
Print ISSN: 0377-7332
Electronic ISSN: 1435-8921
DOI: https://doi.org/10.1007/s00181-015-1053-5

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