Modeling time-varying dependencies between the exchange rate and relative price: A common factor approach

This dissertation explores the common factor in conditional distributions for the bivariate time series approach, specifically focusing on the dynamic relationship between the TRY-USD exchange rate and the Turkey-US relative Consumer Price Index. Utilizing the conditional copulas, the study aims to identify third variables, interest rate differentials, relative industrial production index, and relative money supply, that may serve as common factors influencing the conditional dependence between the exchange rate and relative prices. The methodological framework integrates autoregressive and generalized autoregressive conditional heteroscedasticity models to estimate marginal distributions of the exchange rate and the relative price index in the first step, and the copula conditioned on a third variable in the second. Following this, both static and time-varying Normal and Gumbel copulas are employed to capture symmetric and asymmetric dependencies, respectively. Utilizing the moving block bootstrap approach, the study aims to provide robustness in hypothesis testing regarding the impact of conditioning variables on the copula parameters. Empirical findings reveal that the interest rate differential, relative industrial production index, and relative money supply exhibit common factor characteristics. These variables significantly influence the marginal distributions of the exchange rate and relative price index while leaving the copula's dependence structure unaffected, affirming their role as common factors. Additionally, the study highlights the efficiency of time-varying copulas in capturing the evolving and complex dependency structures intrinsic to macroeconomic relationships. This research contributes to the econometric literature by bridging theoretical advancements in copula modeling with empirical applications in macroeconomic analysis. It offers valuable insights into the determinants of exchange rate and price volatilities, with critical implications for monetary policy and the management of macroeconomic shocks. By portraying the role of common factors, the dissertation enhances the understanding of the dynamic interplay between the exchange rate and inflationary pressures within an integrated econometric framework. Keywords: Common factor, conditional distribution, time-varying dependencies, copula.