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

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Abstract

The paper tests for nonlinearities in the adjustment of the euro exchange rate towards purchasing power parity (PPP). It presents new survey based evidence consistent with non-linear patterns in euro exchange rate dynamics. Moreover, based on an exponential smooth transition autoregressive (ESTAR-) model, it finds strong evidence that the speed of mean reversion in euro exchange rates increases non-linearly with the magnitude of the PPP deviation. Accordingly, while the euro real exchange rate can be well approximated by a random walk if PPP deviations are small, in periods of significant deviations, gravitational forces are set to take root and bring the exchange rate back towards its long-term trend. Consistent with higher euro-dollar volatility, deviations from the PPP equilibrium for this pair need to be stronger in order to reach the same adjustment intensity as for other currencies. JEL Classification: F31.

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Bibliographic Info

Paper provided by European Central Bank in its series Working Paper Series with number 682.

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Length: 25 pages
Date of creation: Oct 2006
Date of revision:
Handle: RePEc:ecb:ecbwps:20060682

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Keywords: Purchasing power parity; real exchange rate; non-linearities; STAR models.;

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References

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Cited by:
  1. Jan Willem van den End, 2011. "Statistical evidence on the mean reversion of interest rates," DNB Working Papers 284, Netherlands Central Bank, Research Department.

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