| dc.description.abstract | The thesis examines empirically the sustainability of the Latvian lats' peg to
SDR. It aims at identifying fundamental and non-fundamentals risk factors, and the
changing structure of the risks that have been instrumental in inducing exchange rate
instability. Following the unobserved components model (see Pagan [1996]), the
exchange rate is decomposed into a permanent and transitory parts, and risks to the peg's
sustainability are investigated via analysing dynamics of each part separately.
The risks arising from the deviation of the permanent part from the underlying
equilibrium rate driven by economic fundamentals are investigated using the Behavioural
Equilibrium Exchange Rate framework, see Clark and MacDonald [1999]. Econometric
modelling is based on the system cointegration method of Johansen [1988, 1995] and
single-equation methods of two-step Engle-Granger [1987] and Banerjee et al [1993].
Dynamics of three alternative measures of the real effective exchange rates vis-a-vis
Latvia's nine major trade partners are investigated using a quarterly data set.
For the transitory part, the destabilising impact of foreign shocks is investigated
in two steps. Firstly, we adopt Masson's [1998] framework to categorise shocks into
monsoonal effects, spillovers, pure contagion. We study susceptibility to foreign
currency shocks and assess the relative importance of trade and financial linkages to
propagate such shocks using monthly data. The theoretical framework is a standard intertemporal
cost minimisation theory. Quadratic cost function is linked to an
autoregressive-distributed-lags model, which forms a generic econometric model for
our investigation. Secondly, we study the credibility of the peg, the intervention policy
of the Bank of Latvia, and the susceptibility to foreign currency, interest rate and
market risk shocks using daily data. The theoretical framework is based on the target
zone literature developing from Krugman [1991]. The method of empirical target zone
modelling is based on Bekaert and Gray [1998]. Unlike Bekaert and Gray, we: (i) do
not use a jump specification; (ii) measure the intensity of mean reversion and
conditional volatility separately on the strong and weak sides of the currency band; (iii)
propose a simple ad hoc method to test for non-linearity. The external susceptibility is
analysed by implanting foreign shock variables into the target zone model. Disparity in
market response arising from the size of a shock is modelled. Econometric models are
augmented by the FIGARCH( 1 ,d, 1) conditional volatility model of Baillie et al [1996]. | en_US |
