| This paper introduces the threshold cointegration recently developed by Balke and Fomby (1997) and examines its possible applications in economic and financial researches. The threshold cointegration is simply an application of conventional linear-cointegration analysis. If the equilibrium residuals follow the threshold autoregressive process instead of a linear autoregressive regressive process. Balke and Fomby (1997) suggest the two-step procedure of estimating threshold cointegration involved in global behavior and local behavior of equilibrium residuals. The beauty of this methodology is that the concept of a threshold is well founded in economic and financial theory.;The first application of threshold cointegration is to identify the Federal Reserve reaction function based on the long-run money demand function. If there exists a stable long-run demand function, then the money-demand function may follow the threshold cointegration. The long-run money demand function implies that a dramatic deviation from the thresholds (excess money supply or excess money demand), then the Fed will actively intervene with monetary policy. If deviations are moderate, then the Fed will not conduct an active policy.;As predicted, the money demand function (based on the narrow definition of money M1, federal funds rate, and industrial production) follows threshold cointegration by separating the whole regime into three (upper, middle, and lower) regimes. Each regime is analyzed via threshold error correction model and I find that the Fed uses the federal funds rate as a policy tool except for the upper regime. In addition, I find that the Fed exploits the liquidity effect, at least in the lower regime. These results highlight that the interest rate plays an important role as explained by McCallum (1983).;The second application of threshold cointegration is to estimate an empirical arbitrage band based on an equilibrium framework of the covered interest parity condition. Clinton (1988) estimates a 0.06% transaction-costs band by using the trading rules. The results by using threshold cointegration also produce similar results. The dynamics of exchange rates for Germany, U.K., Japan, and Switzerland are analyzed by using the cointegrated structural VAR model. The result supports Dornbusch's (1976) sticky price model which relaxed the assumption of continuous PPP. |
