Using Dynamic Principal Components to Estimate an Alternative Measure of Exchange Market Pressure

Abstract

Measures of Exchange Market Pressure (EMP) combine exchange-rate depreciations, reserve losses, and interest-rate hikes into a single index, for the purpose of explaining or predicting currency crisis. The standard measure assigns variance-smoothing weights that are fixed throughout the sample periods. Here, we extend the static PCA analysis of Hegerty (2013) to model EMP using the Dynamic Principal Components (DPCA) approach of Forni et al. While the DPCA and the: “standard” measure match in certain cases, they diverge widely in others, suggesting that this alternative must be refined before it can be used in wider practice.