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Smooth transition models and arbitrage consistency

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  • D Peel
  • I A Venetis

Abstract

Slow adjustment of real exchange rate towards its long run equilibrium in linear models has long puzzled researchers and provided the impetus for the adoption of particular classes of nonlinear models. The exponential smooth transition model has been particularly successful as an ex post characterization of time series purchasing power parity data providing faster adjustment speeds. In this paper we discuss some of its theoretical limitations as an ex ante data generating mechanism since one interpretation of it is that expectations are adaptive. We propose a new nonlinear model which is conceptually superior to the ESTAR model since it is consistent with rational expectations. One of the advantages of the model is that it can be solved and estimated by nonlinear least squares. Using monthly post-1973 real exchange rate data, we show that the model implies even faster speeds of adjustment.

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Bibliographic Info

Paper provided by Lancaster University Management School, Economics Department in its series Working Papers with number 566786.

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Date of creation: 2005
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Handle: RePEc:lan:wpaper:566786

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References

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Cited by:
  1. Liu, Yan & Chang, Hsu-Ling & Su, Chi-Wei, 2013. "Do real interest rates converge across East Asian countries based on China?," Economic Modelling, Elsevier, vol. 31(C), pages 467-473.
  2. Jiang, Chun & Li, Xiao-Lin & Chang, Hsu-Ling & Su, Chi-Wei, 2013. "Uncovered interest parity and risk premium convergence in Central and Eastern European countries," Economic Modelling, Elsevier, vol. 33(C), pages 204-208.
  3. Giorgio Valente & H. L. Leon & Lucio Sarno, 2006. "Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle," IMF Working Papers 06/136, International Monetary Fund.
  4. Paya, Ivan & Peel, David A. & Spiru, Alina, 2010. "The forward premium puzzle in the interwar period and deviations from covered interest parity," Economics Letters, Elsevier, vol. 108(1), pages 55-57, July.
  5. Lin, Jeng-Bau & Liang, Chin-Chia & Yeh, Ming-Liang, 2011. "Examining nonlinear dynamics of exchange rates and forecasting performance based on the exchange rate parity of four Asian economies," Japan and the World Economy, Elsevier, vol. 23(2), pages 79-85, March.
  6. Copeland, Laurence & Lu, Wenna, 2013. "Dodging the Steamroller: Fundamentals versus the Carry Trade," Cardiff Economics Working Papers E2013/11, Cardiff University, Cardiff Business School, Economics Section, revised Dec 2013.

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