Is reversion to PPP in euro exchange rates non-linear?

Abstract

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Non-technical summary Terms of use: Documents in EconStor mayThe wide fluctuations in the euro exchange rate since its launch in 1999 call for a deeper understanding of the underlying relationships. From a policy perspective, it is particularly useful to understand of whether and when exchange rate changes constitute movements towards or away from some long-term equilibrium level. While there are various ways to think about equilibrium exchange rates, this paper focuses on the universal starting point of applied exchange rate analysis which is to compare the current exchange rate against some measure of purchasing power parity (PPP). In its relative version, PPP states that nominal exchange rates move in proportion to relative developments in domestic and foreign prices implying a constant real exchange rate. While visual inspection seems to support that the euro real exchange rates oscillate around a mean in the long run, more rigorous statistical tests commonly fail to confirm such mean reverting properties.This finding should not lead us to the conclusion to discard drawing inferences from PPP analysis. Several caveats caution against a too strict interpretation of such tests of PPP. These include the lack of power of the tests themselves, the real exchange rate interaction with economic fundamentals (such as different trends in productivity) and the presence of nonlinearities in the mean reversion process. This paper investigates the latter aspect.Non-linearities in the adjustment of exchange rates can be justified from both a goods and a financial market perspective. As international goods arbitrage involves transaction costs, arbitrage sets in once the real exchange rate protractedly moves outside certain limits. From an asset market perspective, differing trading strategies could play a role with "Chartists" dominating market dynamics when the exchange rate is close to some perceived equilibrium, while "Fundamentalists" being at play once the exchange rate is increasingly misaligned.Appling this concept to the euro, the presence of such non-linear behaviour is confirmed for the real effective exchange rate of the euro and the two bilateral euro exchange rates with the biggest weight in the euro effective exchange rate, namely the real euro-dollar and the real euro-pound sterling exchange rates. Specifically, using a smooth transition autoregressive (STAR-) model, we find that the further away the real exchange rate moves from PPP, the stronger th...

Productivity Convergence : Is Anyone Catching Up?

“…These are conducted infrequently and not available for all countries, hence subject to considerable measurement error and extrapolation to countries and years with missing data. PPP exchange rates tend to be more stable than market exchange rates (Schnatz, 2007). Hence, for weighting purposes, market exchange rates are typically fixed at the value of a specific year or period by the World Bank, and can therefore be influenced by short-term fluctuations that occurred in the chosen period.…”

The US Dollar/Euro Exchange Rate: Structural Modeling and Forecasting During the Recent Financial Crises

“…Other studies have provided evidence of convergence towards purchasing power parity (PPP) in the euro area. In particular, Lopez and Papell (2007), using panel data methods, find evidence of PPP within the eurozone and between the eurozone and its main partners over the period 1972-2001similarly, Koedijk et al (2004) and Schnatz (2007) over the periods 1973-2003 and 1980-2006, respectively. 1 The validity of the monetary model of exchange rate determination has also been directly assessed in recent studies.…”

Dynamics of the real exchange rate in European emerging economies: Evidence from quantile regression

“…Assumption that dynamics adjustment is stable, regardless of the size of the shock and its impact on the distance of the RER from the equilibrium level, is increasingly viewed as one of the main reasons for the PPP hypothesis rejection. In fact, the considerable asymmetry in the adjustment of the RER is empirically confirmed in a number of articles (Mark P. Taylor, David A. Peel, and Lucio Sarno 2001;Bernd Schnatz 2006;Hassan Shirvani and Natalya Delcoure 2012). Such asymmetry implies that the smaller size of the shocks causes significant persistence of the RER, whereas the rate of return to equilibrium PPP level is disproportionally faster after greater shocks resulted in far more serious deviations.…”