Further Evidence on PPP Adjustment Speeds: the Case of Effective Real Exchange Rates and the EMS*

Abstract

Two different approaches intend to resolve the 'puzzling' slow convergence to purchasing power parity (PPP) reported in the literature [see Rogoff (1996), Journal of Economic Literature, Vol. 34.] On the one hand, there are models that consider a non-linear adjustment of real exchange rate to PPP induced by transaction costs. Such costs imply the presence of a certain transaction band where adjustment is too costly to be undertaken. On the other hand, there are models that relax the 'classical' PPP assumption of constant equilibrium real exchange rates. A prominent theory put together by BS effect, suggests that a non-constant real exchange rate equilibrium is induced by different productivity growth rates between countries. This paper reconciles those two approaches by considering an exponential smooth transition-in-deviation non-linear adjustment mechanism towards non-constant equilibrium real exchange rates within the EMS (European Monetary System) and effective rates. The equilibrium is proxied, in a theoretically appealing manner, using deterministic trends and the relative price of non-tradables to proxy for BS effects. The empirical results provide further support for the hypothesis that real exchange rates are well described by symmetric, nonlinear processes. Furthermore, the half-life of shocks in such models is found to be dramatically shorter than that obtained in linear models.

The confusing time-series behaviour of real exchange rates: Are asymmetries important?

“…Moreover, however, there are a variety of other models all claiming to accurately describe the dynamics of international real exchange rates, for which examples include the modified LSTAR model (Sollis et al, 2002), the non-linear trend-stationary model (Sollis, 2005), the multiple-regime STAR model (Bec et al, 2004) and the fractionally-integrated STAR model (Smallwood, 2005). Whilst, more recent further evidence supporting non-linear reversion is proved by Paya et al (2003), Chortareas and Kapetanios (2004) and Paya and Peel (2007).…”

Revisiting real interest rate parity in BRICS countries using ADL test for threshold cointegration

“…All these motivate us to use the Autoregressive Distributed Lag (hereafter, ADL) test for threshold (asymmetric) cointegration in our study. 1 This study revisits real interest rate parity (RIP) using a newly developed ADL test for threshold cointegration, proposed by Li and Lee (2010), for BRICS countries against 1 As we know, interest rate differentials may be nonlinear due to transaction costs, central bank intervention, the downward rigidity of prices (Scholnick 1996) and asymmetric adjustment in real exchange rates (Paya et al 2003). In such cases, the threshold cointegration methodology is particularly relevant.…”

Forecasting exchange rates: Non-linear adjustment and time-varying equilibrium

“…In particular, while early work on the real exchange rate often reported unit root behaviour in violation of PPP (see, for example, Meese and Rogoff, 1988;Enders, 1988;Taylor, 1988;Mark, 1990), following the work of Obstfeld and Taylor (1997) and Taylor et al (2001) the real exchange rate is typically modelled as a non-linear process, with an inner regime characterised by random walk behaviour and an outer regime characterised by reversion. Following the original work, a series of papers has supported such non-linear mean reversion (examples include, Sollis et al, 2002;Paya et al, 2003;Bec et al, 2004;Chortareas and Kapetanios, 2004;Sollis, 2005;Smallwood, 2005;Paya and Peel, 2007;McMillan, 2009).…”