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How well does nonlinear mean reversion solve the PPP puzzle?

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  • Norman, Stephen
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    Abstract

    This paper addresses the degree to which models which exhibit nonlinear mean reversion (NMR) present a resolution to the Purchasing Power Parity Puzzle. This paper develops a method of estimating a representative distribution of half lives which is based upon the observed distribution of shocks in a given time series rather than choosing shock sizes arbitrarily which is the current practice in the literature. This approach is implemented with data on five real exchange rates. The empirical analysis shows that half lives shorter than the consensus are observed frequently enough to support the proposition that NMR is a solution to the PPP puzzle.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of International Money and Finance.

    Volume (Year): 29 (2010)
    Issue (Month): 5 (September)
    Pages: 919-937

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    Handle: RePEc:eee:jimfin:v:29:y:2010:i:5:p:919-937

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    Web page: http://www.elsevier.com/locate/inca/30443

    Related research

    Keywords: C22 F31 Nonlinear impulse response analysis Purchasing power parity Half life Smooth transition autoregressive model Real exchange rates;

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    References

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    1. Sarno, Lucio & Valente, Giorgio, 2006. "Deviations from purchasing power parity under different exchange rate regimes: Do they revert and, if so, how?," Journal of Banking & Finance, Elsevier, vol. 30(11), pages 3147-3169, November.
    2. Gallant, A Ronald & Rossi, Peter E & Tauchen, George, 1993. "Nonlinear Dynamic Structures," Econometrica, Econometric Society, vol. 61(4), pages 871-907, July.
    3. Koop, Gary & Pesaran, M. Hashem & Potter, Simon M., 1996. "Impulse response analysis in nonlinear multivariate models," Journal of Econometrics, Elsevier, vol. 74(1), pages 119-147, September.
    4. JamesR. Lothian & MarkP. Taylor, 2008. "Real Exchange Rates Over the Past Two Centuries: How Important is the Harrod-Balassa-Samuelson Effect?," Economic Journal, Royal Economic Society, vol. 118(532), pages 1742-1763, October.
    5. Alvaro Escribano & Oscar Jorda, . "Improved Testing And Specification Of Smooth Transition Regression Models," Department of Economics 97-26, California Davis - Department of Economics.
    6. Christopher F. Baum & Mustafa Caglayan & John Barkoulas, 1998. "Nonlinear Adjustment to Purchasing Power Parity in the post-Bretton Woods Era," Boston College Working Papers in Economics 404., Boston College Department of Economics, revised 16 Nov 1999.
    7. Christian J. Murray & David H. Papell, 2000. "The Purchasing Power Parity Persistence Paradigm," Econometric Society World Congress 2000 Contributed Papers 0017, Econometric Society.
    8. Sarno, Lucio & Taylor, Mark P. & Chowdhury, Ibrahim, 2004. "Nonlinear dynamics in deviations from the law of one price: a broad-based empirical study," Journal of International Money and Finance, Elsevier, vol. 23(1), pages 1-25, February.
    9. Taylor, Mark P & Peel, David A & Sarno, Lucio, 2001. "Nonlinear Mean-Reversion in Real Exchange Rates: Toward a Solution to the Purchasing Power Parity Puzzles," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 42(4), pages 1015-42, November.
    10. Taylor, Mark P. & Peel, David A., 2000. "Nonlinear adjustment, long-run equilibrium and exchange rate fundamentals," Journal of International Money and Finance, Elsevier, vol. 19(1), pages 33-53, February.
    11. Kenneth Rogoff, 1996. "The Purchasing Power Parity Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 647-668, June.
    12. Michael, Panos & Nobay, A Robert & Peel, David A, 1997. "Transactions Costs and Nonlinear Adjustment in Real Exchange Rates: An Empirical Investigation," Journal of Political Economy, University of Chicago Press, vol. 105(4), pages 862-79, August.
    13. Kapetanios, George & Shin, Yongcheol & Snell, Andy, 2003. "Testing for a unit root in the nonlinear STAR framework," Journal of Econometrics, Elsevier, vol. 112(2), pages 359-379, February.
    14. Hansen Bruce E., 1997. "Inference in TAR Models," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 2(1), pages 1-16, April.
    15. Paya, Ivan & Peel, David A., 2006. "On the speed of adjustment in ESTAR models when allowance is made for bias in estimation," Economics Letters, Elsevier, vol. 90(2), pages 272-277, February.
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    Cited by:
    1. Beckmann, Joscha, 2013. "Nonlinear adjustment, purchasing power parity and the role of nominal exchange rates and prices," The North American Journal of Economics and Finance, Elsevier, vol. 24(C), pages 176-190.
    2. Mark J. Holmes & Jesus Otero & Theodore Panagiotidis, 2011. "PPP in OECD countries: An analysis of real exchange rate stationarity, cross-sectional dependency and strucutral breaks," Discussion Paper Series 2011_17, Department of Economics, University of Macedonia, revised Nov 2011.
    3. Ca' Zorzi, Michele & Muck, Jakub & Rubaszek, Michał, 2013. "Real exchange rate forecasting: a calibrated half-life PPP model can beat the random walk," Working Paper Series 1576, European Central Bank.

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