Exchange Rates and Inflation Rates: Exploring Nonlinear Relationships

This paper investigates the Purchasing Power Parity Theory (PPP) in the context of possible nonlinear relationships between prices and exchange rates of three key currencies. The main contribution of this paper is testing for nonlinearities and nonlinear relationships in a framework of information arrival. Three issues motivated the paper. First, research interest in exchange rate fluctuations, PPP, and exchange rate pass through. Second, market volatilities have triggered curiosity in nonlineraities in various economic and financial time series and nonlinear relationships and chaos in financial markets. For instance, the study of chaotic behavior may shed some light on the nature of latent nonlinearities. Third, developments in the econometrics of nonlinearity in the last three decades offer researchers new tools for detecting relationships that are inherently nonlinear and may not be conducive to various methodologies that are seeking to impose linear modeling on nonlinear relationships. Our findings show strong evidence that the exchange series exhibit nonlinear dependencies that may be inconsistent with chaotic structure. We identify GARCH(1,1) process as the model that best explains the nonlinearities in the monthly exchange rates and inflation rates. Therefore, we propose and estimate bivariate GARCH(1,1) models of the variances to ascertain the flow of information between exchange rates and prices. Bivariate GARCH models show that, the volatility spillover and information arrival between exchange rates and price levels occur simultaneously. Thus, we find support for the PPP theory and exchange rate pass through in the economies under consideration. We conclude that two theories, i.e., the exchange rate pass through and PPP may simultaneously hold the key to exchange rate analysis.