xxvi Editors’ Introduction
to a considerable number of empirical papers in this area. Thus, the question of
“Where are we now?” is not one with a short answer. Perhaps prototypically, the
econometrics of exchange rates is an area that has moved in tandem with devel-
opments in the economic theory of exchange rates (for the latter, the reader is
referred to, for example, Sarno and Taylor, 2002). An enduring question over the
last thirty years (at least), and one that is touched upon in two earlier chapters
(Juselius, Chapter 8, and Gil-Alana and Hualde, Chapter 10), has been the status of
PPP, regarded as a bedrock of economic theory and macroeconomic models. One
early finding that has puzzled many is the apparent failure to find PPP supported
by a range of different exchange rates and sample periods. Consider a stylized ver-
sion of the PPP puzzle: there are two countries, with a freely floating exchange
rate, flexible prices (for tradable goods and services), no trade constraints, and
so on. In such a situation, at least in the long run, the nominal exchange rate
should equal the ratio of the (aggregate) price levels, otherwise, as the price ratio
moves, the nominal exchange rate does not compensate for such movements and
the real exchange rate varies over time, contradicting PPP; indeed, on this basis
the exchange rate is not tied to what is happening to prices. Early studies used an
essentially linear framework – for example, ARMA models combined with unit root
tests – to evaluate PPP, and rarely found that it was supported by the data; more-
over, estimated speeds of adjustment to shocks were so slow as to be implausible.
Another puzzle, in which tests indicated that the theory (of efficient speculative
markets) was not supported, was the “forward bias puzzle.” In this case, the pre-
diction was that prices should fully reflect publicly available information, so that
it should not be possible to make a systematic (abnormal) return; however, this
appeared not to be the case. In this chapter, Pavlidiset al. carefully dissect this and
other puzzles and show how the move away from simple linear models to a range
of essentially nonlinear models, the development and application of multivariate
models, and the use of panel data methods, has provided some explanation of the
exchange rate “puzzles.”
Part VIII of this volume of theHandbookis comprised of three chapters related to
what has become referred to as “growth econometrics”; broadly speaking, this is the
area that is concerned with variations in growth rates and productivity levels across
countries or regions. Chapters 23 and 24 are a coordinated pair by Steven Durlauf,
Paul Johnson and Jonathan Temple; in addition, looking ahead, Chapter 27 by
Serge Rey and Julie Le Gallo takes up aspects of growth econometrics, with an
emphasis on spatial connections. In Chapter 23, Durlaufet al.focus on the econo-
metrics of convergence. Of course, convergence could and does mean a number of
things: first, the convergence of what? Usually this is a measure of income or out-
put but, in principle, the question of whether two (or more) economies are/have
converged relates to multiple measures, for example, output, inflation, unemploy-
ment rates, and so on, and possibly includes measures of social welfare, such as
literacy and mortality rates. The first concept to be considered in Chapter 23 is
β-convergence (so-called because the key regression coefficient is referred to asβ):
consider two countries; there isβ-convergence if the one with a lower initial income
grows faster than the other and so “catches up” with the higher-income country.