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Mean-reversion vs. adjustment to PPP: the two regimes of exchange rate dynamics under the EMS, 1979-1998

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  • Bessec, Marie

Abstract

This paper examines jointly the empirical relevance of the mean-reversion and the PPP hypotheses in the exchange rate dynamics under the EMS. Given the non-stationarity and the non-linearities characterizing the foreign exchange rate dynamics, this question is studied using a MS-ECM model: it allows a discontinuous adjustment towards the cointegration relationship. We find that the European exchange rates of the ERM members display mean-reversion towards the central parity in the credible regime, whereas they adjust to the PPP during the volatile period. The first mechanism is due to the stabilizing effect of a credible target-zone, while the second one can be explained by the realignments made in accordance with the underlying inflation rates.

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Bibliographic Info

Article provided by Elsevier in its journal Economic Modelling.

Volume (Year): 20 (2003)
Issue (Month): 1 (January)
Pages: 141-164

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Handle: RePEc:eee:ecmode:v:20:y:2003:i:1:p:141-164

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Web page: http://www.elsevier.com/locate/inca/30411

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Cited by:
  1. Yuliya Lovcha & Alejandro Perez-Laborda, 2010. "Is exchange rate – customer order flow relationship linear? Evidence from the Hungarian FX market," MNB Working Papers 2010/10, Magyar Nemzeti Bank (the central bank of Hungary).
  2. Bassem Kamar & Jean-Etienne Carlotti & Russell C. Krueger, 2009. "Establishing Conversion Values for New Currency Unions," IMF Working Papers 09/184, International Monetary Fund.
  3. Miller, J. Isaac, 2011. "Testing the bounds: Empirical behavior of target zone fundamentals," Economic Modelling, Elsevier, vol. 28(4), pages 1782-1792, July.
  4. Frommel, Michael & MacDonald, Ronald & Menkhoff, Lukas, 2005. "Markov switching regimes in a monetary exchange rate model," Economic Modelling, Elsevier, vol. 22(3), pages 485-502, May.

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