Real exchange rate, stationarity, and economic fundamentals

Article
First Online:

Abstract

Using monthly data for the US/UK real exchange rate over the period 1921–2002, we find evidence that the mean reverting tendency of the real exchange rate is stochastic, and regime-dependent. There is one regime over which PPP holds as a long-run equilibrium relation, i.e. a stationary PPP regime, and another regime over which PPP does not hold, i.e. a non-stationary PPP regime. The transition from the non-stationary to the stationary regime is found to be affected by the real interest rate differential, and by the volatility of the nominal exchange rate. The real output differential does not appear to affect the transition probability.

Keywords

PPP Regime Switching, Real Interest Rate Differential, Real Output Differential 

JEL Classification

F31 C22 F41 
This is a preview of subscription content, log in to check access.

Notes

Acknowledgements

The author wishes to thank anonymous referees for valuable comments. The kind hospitality of Brunel University and the British Library in collecting data for this research, is gratefully acknowledged.

References

  1. Adler M, Lehmann B (1983) Deviations from purchasing power parity in the long run. J Finance 38:1471–1487CrossRefGoogle Scholar
  2. Bleaney M, Leybourne SJ, Mizen P (1999) Mean reversion of real exchange rates in high- inflation countries. Discussion Paper 99/13, University of NottinghamGoogle Scholar
  3. Caporale GM, Pittis N, Sakellis P (2003) Testing for PPP: the erratic behaviour of unit root tests. Econ Lett 80:277–284CrossRefGoogle Scholar
  4. Carr JL, Floyd JE (2002) Real and monetary shocks to the Canadian dollar: do Canada and the United States form an optimal currency area? N Am J Econ Finance 13:21–39CrossRefGoogle Scholar
  5. Cavaliere G (2003) Asymptotics for unit roots under Markov regime-switching. Econom J 6(1):193–216CrossRefGoogle Scholar
  6. Chen N (2004) The behaviour of relative prices in the European Union: a sectoral analysis. Eur Econ Rev 48:1257–1286CrossRefGoogle Scholar
  7. Cheung YW, Lai KS (1993) A fractional cointegration analysis of purchasing power parity. J Bus Econ Stat 11:103–112CrossRefGoogle Scholar
  8. Cheung Y-W, Lai KS, Bergman M (2004) Dissecting the PPP puzzle: the unconventional roles of nominal exchange rate and price adjustments. J Int Econ 64:135–150CrossRefGoogle Scholar
  9. Chortareas GE, Kapetanios G, Shin Y (2002) Nonlinear mean reversion in real exchange rates. Econ Lett 77:411–417CrossRefGoogle Scholar
  10. Clarida R, Gali J (1994) Sources of real exchange rate fluctuations: how important are nominal shocks? Carnegie-Rochester Conf Ser Public Policy 41:1–56CrossRefGoogle Scholar
  11. Coe PJ, Serletis A (2002) Bounds tests of the theory of purchasing power parity. J Bank Financ 26:179–199CrossRefGoogle Scholar
  12. Corbae D, Ouliaris S (1991) A test of long-run purchasing power parity allowing for structural breaks. Econ Rec 67:26–33CrossRefGoogle Scholar
  13. Davidson J (2004) Time Series Modeling, http://www.cf.ac.uk/carbs/econ/davidsonje/
  14. Davies RB (1987) Hypothesis testing when the nuisance parameter is present only under the alternative. Biometrika 74:33–43Google Scholar
  15. Davis G, Miller NC (1996) Exchange rate mean reversion from real shocks within an intertemporal model. J Int Money Financ 15:947–967CrossRefGoogle Scholar
  16. Diebold FX, Lee J-H, Weinbach G (1994) Regime switching with time-varying transition probabilities. In: Hargreaves C (ed) Nonstationary time series analysis and cointegration. Oxford University Press, Oxford, pp 283–302Google Scholar
  17. Dornsbusch R (1976) Expectations and exchange rate dynamics. J Polit Econ 84(6):1161–1176CrossRefGoogle Scholar
  18. Dumas B (1992) Dynamic equilibrium and the real exchange rate in a spatially separated world. Rev Financ Stud 5(2):153–180CrossRefGoogle Scholar
  19. Edison HJ (1987) Purchasing power parity in the long-run: a test of the dollar/pound exchange rate (1890–1978). J Money Credit Bank 19(3):376–387CrossRefGoogle Scholar
  20. Elliott G (1999) Efficient tests for a unit root when the initial observation is drawn from its unconditional distribution. Int Econ Rev 40:767–783CrossRefGoogle Scholar
  21. Elliott G, Rothenberg T, Stock JH (1996) Efficient tests for an autoregressive unit root. Econometrica 64:813–836CrossRefGoogle Scholar
  22. Engel C, Kim CJ (2001) The long-run US/UK real exchange rate. J Money Credit Bank 31(3):335–356CrossRefGoogle Scholar
  23. Engel C, Rogers JH (2001) Deviations from purchasing power parity: causes and welfare costs. J Int Econ 55:29–57CrossRefGoogle Scholar
  24. Filardo A (1994) Business cycles phases and their transitional dynamics. J Bus Econ Stat 12:299–308CrossRefGoogle Scholar
  25. Frenkel J (1976) A monetary approach to the exchange rate: doctrinal aspects and empirical evidence. Scand J Econ 78:255–276CrossRefGoogle Scholar
  26. Frommel M, MacDolad R, Menkhoff L (2002) Markov switching in a monetary exchange rate model. Discussion paper 266, November, 1–31Google Scholar
  27. Genberg H (1978) Purchasing power parity under fixed and flexible exchange rates. J Int Econ 8(2):247–276CrossRefGoogle Scholar
  28. Giovannini A (1988) Exchange rates and traded goods prices. J Int Econ 24:45–68CrossRefGoogle Scholar
  29. Glen JD (1992) Real exchange rates in the short-run, medium, and long run. J Int Econ 33(1–2):147–166CrossRefGoogle Scholar
  30. Goswami G, Shrikhande M, Wu L (2004) A dynamic equilibrium model of real exchange rates with general transaction costs. Working Paper, October, Fordham University, 1–28Google Scholar
  31. Granger CWJ, Swanson NR (1997) An introduction to stochastic unit-root processes. J Econ 80:35–62Google Scholar
  32. Grilli V, Kaminsky G (1991) Nominal exchange rate regimes and the real exchange rate. J Monet Econ 27:191–212CrossRefGoogle Scholar
  33. Hall A (1994) Testing for a unit root in time series with pretest data-based model selection. J Bus Econ Stat 12:461–470CrossRefGoogle Scholar
  34. Hall S, Psaradakis Z, Sola M (1997) Detecting periodically collapsing bubbles: a Markov-switching unit root test. J Appl Econ 14:143–154CrossRefGoogle Scholar
  35. Hegwood N, Papell DH (1998) Quasi purchasing power parity. Int J Financ Econ 3:279–289CrossRefGoogle Scholar
  36. Johansson M (2001) TAR models and real exchange rates. Working Paper, November, Department of Economics, Lund University, 1–16Google Scholar
  37. Kanas A, Genius M (2005) Regime (non)stationarity in the US/UK real exchange rate. Econ Lett 87(3):407–413CrossRefGoogle Scholar
  38. Knetter M (1993) International comparisons of pricing to market behavior. Am Econ Rev 83:473–486Google Scholar
  39. Leybourne SJ, McCabe BPM, Tremayne AR (1996) Can economic time series be differenced to stationarity? J Bus Econ Stat 14(4):435–446CrossRefGoogle Scholar
  40. Liu PC (1992) Purchasing power parity in Latin America: a cointegration analysis. Weltwirtsch Arch 128:66–79CrossRefGoogle Scholar
  41. Lopez C, Murray C, Papell D (2005) State of the art unit root tests and purchasing power parity. J Money Credit Bank 37:361–369CrossRefGoogle Scholar
  42. Lothian JR, Taylor MP (1996) Real exchange rate behaviour: the recent float from the perspective of the past two centuries. J Polit Econ 104:488–510CrossRefGoogle Scholar
  43. Lothian JR, Taylor MP (1997) Real exchange rate behaviour: the problem of power and sample size. J Int Money Financ 16:945–954CrossRefGoogle Scholar
  44. Marston R (1990) Pricing to market in Japanese manufacturing. J Int Econ 29:217–236CrossRefGoogle Scholar
  45. McNown R, Wallace MS (1989) National price levels, purchasing power parity, and cointegration: a test of four high inflation countries. J Int Money Financ 8:533–545CrossRefGoogle Scholar
  46. McNown R, Wallace MS (1994) Cointegration tests of the monetary exchange rate model for high-inflation economies. J Money Credit Bank 26:396–411CrossRefGoogle Scholar
  47. Meese R, Rogoff K (1988) Was it real? The exchange rate-interest differential relation over the modern floating-rate period. J Finance 43(4):933–948CrossRefGoogle Scholar
  48. Meltzer A (1993) Real exchange rates: some evidence from the postwar years. Federal Reserve Bank of St Louis Review, March/April, 103–117Google Scholar
  49. Michael P, Nobay R, Peel DA (1997) Transaction costs and nonlinear adjustment in real exchange rates: an empirical investigation. J Polit Econ 105:862–879CrossRefGoogle Scholar
  50. Mills T, Pentecost E (2003) Is there a relationship between real exchange rate movements and the output cycle? Econ Model 20:593–603CrossRefGoogle Scholar
  51. Montanes A (2000) Unit roots, level shifts and purchasing power parity. Working Paper, Department of Economic Analysis, University of ZaragosaGoogle Scholar
  52. Ng S, Perron P (1997) Estimation and inference in nearly unbalanced nearly cointegrated systems. J Econ 79:53–81Google Scholar
  53. Pippenger M, Goering G (1993) A note on the empirical power of unit root tests under threshold processes. Oxf Bull Econ Stat 55(4):473–481Google Scholar
  54. Rahbek A, Shephard N (2002) Inference and ergodicity in the autoregressive conditional root model. Working Paper, Nuffield College, OxfordGoogle Scholar
  55. Rogers JH (1999) Monetary shocks and real exchange rates. J Int Econ 49:269–288CrossRefGoogle Scholar
  56. Sarno L, Taylor MP (2002) The economics of exchange rates. Cambridge University Press, CambridgeGoogle Scholar
  57. Serletis A, Gogas P (2004) Long-horizon regression tests of the theory of purchasing power parity. J Bank Financ 28:1961–1985CrossRefGoogle Scholar
  58. Serletis A, Zimonopoulos G (1997) Breaking trend functions in real exchange rates: evidence from seventeen OECD countries. J Macroecon 19:781–802CrossRefGoogle Scholar
  59. Sollis R, Leybourne S, Newbold P (2002) Tests for symmetric and asymmetric nonlinear mean reversion in real exchange rates. J Money Credit Bank 34:686–700CrossRefGoogle Scholar
  60. Taylor AM (2002) A century of purchasing power parity. Rev Econ Stat 84:139–150CrossRefGoogle Scholar
  61. Taylor MP, Peel DA, Sarno L (2001) Nonlinear mean-reversion in real exchange rates: towards a solution to the purchasing power parity puzzles. Int Econ Rev 42:1015–1042CrossRefGoogle Scholar
  62. Warren GF, Pearson FA (1932) Wholesale prices for 213 years. Cornell University Press, IthacaGoogle Scholar
  63. Weber A (1997) Sources of purchasing power parity disparities between the G7 economies. J Jpn Int Econ 11:548–583CrossRefGoogle Scholar

Copyright information

© Springer Science+Business Media, LLC 2008

Authors and Affiliations

  1. 1.Department of EconomicsUniversity of CreteCreteGreece
  2. 2.IACMFORTHCreteGreece

Personalised recommendations