IDEAS home Printed from https://ideas.repec.org/p/rug/rugwps/10-667.html
   My bibliography  Save this paper

What do we know about real exchange rate nonlinearities?

Author

Listed:
  • R. KRUSE
  • M. FRÖMMEL
  • L. MENKHOFF
  • P. SIBBERTSEN

Abstract

Nonlinear modeling of adjustments to purchasing power parity has recently gained much attention. However, a huge body of the empirical literature applies ES- TAR models and neglects the existence of other competing nonlinear models. Among these, the Markov Switching AR model has a strong substantiation in international finance. Our contribution to the literature is five-fold: First, we compare ESTAR and MSAR models from a unit root perspective. To this end, we propose a new unit root test against MSAR as the second contribution. Thirdly, we study the case of misspeci- fied alternatives in a Monte Carlo setup with real world parameter constellations. The ESTAR unit root test is not indicative, while the MSAR unit test is robust. Fourthly, we consider the case of correctly specified alternatives and observe low power of the ESTAR but not for the MSAR unit root test. Fifthly, an empirical application to real exchange rates suggests that they may indeed be explained by Markov Switching dy- namics rather than ESTAR.

Suggested Citation

  • R. Kruse & M. Frömmel & L. Menkhoff & P. Sibbertsen, 2010. "What do we know about real exchange rate nonlinearities?," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium 10/667, Ghent University, Faculty of Economics and Business Administration.
    • Handle: RePEc:rug:rugwps:10/667
    as

    Download full text from publisher

    File URL: http://wps-feb.ugent.be/Papers/wp_10_667.pdf
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Kenneth Rogoff, 1996. "The Purchasing Power Parity Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 647-668, June.
    2. 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.
    3. 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 1015-1042, November.
    4. Hall, Stephen & Psaradakis, Zacharias & Sola, Martin, 1997. "Switching error-correction models of house prices in the United Kingdom," Economic Modelling, Elsevier, vol. 14(4), pages 517-527, October.
    5. Kilian, Lutz & Taylor, Mark P., 2003. "Why is it so difficult to beat the random walk forecast of exchange rates?," Journal of International Economics, Elsevier, vol. 60(1), pages 85-107, May.
    6. Kanas, Angelos & Genius, Margarita, 2005. "Regime (non)stationarity in the US/UK real exchange rate," Economics Letters, Elsevier, vol. 87(3), pages 407-413, June.
    7. Chi-Young Choi & Young-Kyu Moh, 2007. "How useful are tests for unit-root in distinguishing unit-root processes from stationary but non-linear processes?," Econometrics Journal, Royal Economic Society, vol. 10(1), pages 82-112, March.
    8. Engel, Charles & Hamilton, James D, 1990. "Long Swings in the Dollar: Are They in the Data and Do Markets Know It?," American Economic Review, American Economic Association, vol. 80(4), pages 689-713, September.
    9. Cheung, Yin-Wong & Erlandsson, Ulf G., 2005. "Exchange Rates and Markov Switching Dynamics," Journal of Business & Economic Statistics, American Statistical Association, vol. 23, pages 314-320, July.
    10. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-384, March.
    11. Hansen, Bruce E, 1996. "Inference When a Nuisance Parameter Is Not Identified under the Null Hypothesis," Econometrica, Econometric Society, vol. 64(2), pages 413-430, March.
    12. Francq, C. & Zakoian, J. -M., 2001. "Stationarity of multivariate Markov-switching ARMA models," Journal of Econometrics, Elsevier, vol. 102(2), pages 339-364, June.
    13. 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 862-879, August.
    14. Hall, Stephen G & Psaradakis, Zacharias & Sola, Martin, 1999. "Detecting Periodically Collapsing Bubbles: A Markov-Switching Unit Root Test," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 14(2), pages 143-154, March-Apr.
    15. Paul De Grauwe & Marianna Grimaldi, 2014. "Heterogeneity of Agents, Transactions Costs and the Exchange Rate," World Scientific Book Chapters, in: Exchange Rates and Global Financial Policies, chapter 2, pages 33-70, World Scientific Publishing Co. Pte. Ltd..
    16. Lucio Sarno, 2005. "Viewpoint: Towards a solution to the puzzles in exchange rate economics: where do we stand?," Canadian Journal of Economics, Canadian Economics Association, vol. 38(3), pages 673-708, August.
    17. James D. Hamilton & Baldev Raj, 2002. "New directions in business cycle research and financial analysis," Empirical Economics, Springer, vol. 27(2), pages 149-162.
    18. Garcia, Rene, 1998. "Asymptotic Null Distribution of the Likelihood Ratio Test in Markov Switching Models," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(3), pages 763-788, August.
    19. Kanas, Angelos, 2006. "Purchasing Power Parity and Markov Regime Switching," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(6), pages 1669-1687, September.
    20. Engel, Charles, 1994. "Can the Markov switching model forecast exchange rates?," Journal of International Economics, Elsevier, vol. 36(1-2), pages 151-165, February.
    21. Lucio Sarno & Mark P. Taylor, 2002. "Purchasing Power Parity and the Real Exchange Rate," IMF Staff Papers, Palgrave Macmillan, vol. 49(1), pages 1-5.
    22. Mehmet Caner & Bruce E. Hansen, 2001. "Threshold Autoregression with a Unit Root," Econometrica, Econometric Society, vol. 69(6), pages 1555-1596, November.
    23. Zacharias Psaradakis & Martin Sola & Fabio Spagnolo, 2004. "On Markov error-correction models, with an application to stock prices and dividends," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 19(1), pages 69-88.
    24. Rapach, David E. & Wohar, Mark E., 2006. "The out-of-sample forecasting performance of nonlinear models of real exchange rate behavior," International Journal of Forecasting, Elsevier, vol. 22(2), pages 341-361.
    25. 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.
    26. Kilian, Lutz & Ohanian, Lee E., 2002. "Unit Roots, Trend Breaks, And Transitory Dynamics: A Macroeconomic Perspective," Macroeconomic Dynamics, Cambridge University Press, vol. 6(5), pages 614-632, November.
    27. Patrick J. Coe, 2002. "Power issues when testing the Markov switching model with the sup likelihood ratio test using U.S. output," Empirical Economics, Springer, vol. 27(2), pages 395-401.
    28. Robinson Kruse, 2011. "A new unit root test against ESTAR based on a class of modified statistics," Statistical Papers, Springer, vol. 52(1), pages 71-85, February.
    29. Lee, Tae-Hwy & White, Halbert & Granger, Clive W. J., 1993. "Testing for neglected nonlinearity in time series models : A comparison of neural network methods and alternative tests," Journal of Econometrics, Elsevier, vol. 56(3), pages 269-290, April.
    30. Sarantis, Nicholas, 1999. "Modeling non-linearities in real effective exchange rates," Journal of International Money and Finance, Elsevier, vol. 18(1), pages 27-45, January.
    31. Lothian, James R & Taylor, Mark P, 1996. "Real Exchange Rate Behavior: The Recent Float from the Perspective of the Past Two Centuries," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 488-509, June.
    32. Dumas, Bernard, 1992. "Dynamic Equilibrium and the Real Exchange Rate in a Spatially Separated World," Review of Financial Studies, Society for Financial Studies, vol. 5(2), pages 153-180.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Niels Haldrup & Robinson Kruse & Timo Teräsvirta & Rasmus T. Varneskov, 2013. "Unit roots, non-linearities and structural breaks," Chapters, in: Nigar Hashimzade & Michael A. Thornton (ed.), Handbook of Research Methods and Applications in Empirical Macroeconomics, chapter 4, pages 61-94, Edward Elgar Publishing.
    2. Kaufmann, Hendrik & Kruse, Robinson & Sibbertsen, Philipp, 2012. "On tests for linearity against STAR models with deterministic trends," Economics Letters, Elsevier, vol. 117(1), pages 268-271.
    3. Aloy, Marcel & Boutahar, Mohamed & Gente, Karine & Péguin-Feissolle, Anne, 2011. "Purchasing power parity and the long memory properties of real exchange rates: Does one size fit all?," Economic Modelling, Elsevier, vol. 28(3), pages 1279-1290, May.
    4. 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.
    5. repec:zbw:rwirep:0272 is not listed on IDEAS
    6. Brian M. Lucey & Fergal A. O’Connor, 2013. "Do bubbles occur in the gold price? An investigation of gold lease rates and Markov Switching models," Borsa Istanbul Review, Research and Business Development Department, Borsa Istanbul, vol. 13(3), pages 53-63, September.
    7. Joscha Beckmann, 2011. "Nonlinear Adjustment, Purchasing Power Parity and the Role of Nominal Exchange Rates and Prices," Ruhr Economic Papers 0272, Rheinisch-Westfälisches Institut für Wirtschaftsforschung, Ruhr-Universität Bochum, Universität Dortmund, Universität Duisburg-Essen.
    8. Dinçer Afat & Michael Frömmel, 2020. "An Alternative Version of Purchasing Power Parity," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 25(4), pages 511-517, October.
    9. Burns, Kelly & Moosa, Imad A., 2015. "Enhancing the forecasting power of exchange rate models by introducing nonlinearity: Does it work?," Economic Modelling, Elsevier, vol. 50(C), pages 27-39.
    10. Aaron D. Smallwood, 2016. "A Monte Carlo Investigation of Unit Root Tests and Long Memory in Detecting Mean Reversion in I(0) Regime Switching, Structural Break, and Nonlinear Data," Econometric Reviews, Taylor & Francis Journals, vol. 35(6), pages 986-1012, June.
    11. Leandro Maciel & Rosangela Ballini, 2021. "Functional Fuzzy Rule-Based Modeling for Interval-Valued Data: An Empirical Application for Exchange Rates Forecasting," Computational Economics, Springer;Society for Computational Economics, vol. 57(2), pages 743-771, February.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Hwa-Taek Lee & Gawon Yoon, 2013. "Does purchasing power parity hold sometimes? Regime switching in real exchange rates," Applied Economics, Taylor & Francis Journals, vol. 45(16), pages 2279-2294, June.
    2. Michael Frömmel & Darko B. Vukovic & Jinyuan Wu, 2022. "The Dollar Exchange Rate, Adjustment to the Purchasing Power Parity, and the Interest Rate Differential," Mathematics, MDPI, vol. 10(23), pages 1-17, November.
    3. Lee, Hwa-Taek & Yoon, Gawon, 2007. "Does Purchasing Power Parity Hold Sometimes? Regime Switching in Real Exchange Rates," Economics Working Papers 2007-24, Christian-Albrechts-University of Kiel, Department of Economics.
    4. Miguel Carvalho & Paulo Júlio, 2012. "Digging out the PPP hypothesis: an integrated empirical coverage," Empirical Economics, Springer, vol. 42(3), pages 713-744, June.
    5. 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.
    6. Nikolaou, Kleopatra, 2008. "The behaviour of the real exchange rate: Evidence from regression quantiles," Journal of Banking & Finance, Elsevier, vol. 32(5), pages 664-679, May.
    7. Yoon, Gawon, 2010. "Do real exchange rates really follow threshold autoregressive or exponential smooth transition autoregressive models?," Economic Modelling, Elsevier, vol. 27(2), pages 605-612, March.
    8. Hyginus Leon & Serineh Najarian, 2005. "Asymmetric adjustment and nonlinear dynamics in real exchange rates," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 10(1), pages 15-39.
    9. Bertram, Philip & Ma, Jun & Sibbertsen, Philipp, 2015. "Real exchange rates and economic fundamentals: An investigation based on a Markov-STAR model," Hannover Economic Papers (HEP) dp-565, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
    10. Kleopatra Nikolaou, 2007. "The behaviour of the real exchange rate: Evidence from regression quantiles," Money Macro and Finance (MMF) Research Group Conference 2006 46, Money Macro and Finance Research Group.
    11. Yuan, Chunming, 2011. "The exchange rate and macroeconomic determinants: Time-varying transitional dynamics," The North American Journal of Economics and Finance, Elsevier, vol. 22(2), pages 197-220, August.
    12. Philip Bertram & Teresa Flock & Jun Ma & Philipp Sibbertsen, 2022. "Real Exchange Rates and Fundamentals in a new Markov‐STAR Model," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 84(2), pages 356-379, April.
    13. Xie, Zixiong & Chen, Shyh-Wei & Hsieh, Chun-Kuei, 2021. "Facing up to the polysemy of purchasing power parity: New international evidence," Economic Modelling, Elsevier, vol. 98(C), pages 247-265.
    14. Carlo Altavilla & Paul De Grauwe, 2010. "Non-linearities in the relation between the exchange rate and its fundamentals," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 15(1), pages 1-21.
    15. Nikolaou, Kleopatra, 2006. "The behaviour of the real exchange rate: evidence from regression quantiles," Working Paper Series 667, European Central Bank.
    16. Zied Ftiti & Slim Chaouachi, 2018. "What Can We Learn About the Real Exchange Rate Behavior in the Case of a Peripheral Country?," Journal of Quantitative Economics, Springer;The Indian Econometric Society (TIES), vol. 16(3), pages 681-707, September.
    17. Ivan Paya & David A. Peel, 2006. "Temporal aggregation of an ESTAR process: some implications for purchasing power parity adjustment," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 21(5), pages 655-668, July.
    18. Gawon Yoon, 2010. "Nonlinear mean-reversion to purchasing power parity: exponential smooth transition autoregressive models and stochastic unit root processes," Applied Economics, Taylor & Francis Journals, vol. 42(4), pages 489-496.
    19. Su Zhou & Mohsen Bahmani-Oskooee & Ali M. Kutan, 2008. "Purchasing Power Parity before and after the Adoption of the Euro," Review of World Economics (Weltwirtschaftliches Archiv), Springer;Institut für Weltwirtschaft (Kiel Institute for the World Economy), vol. 144(1), pages 134-150, April.
    20. Wali, Muammer & Chan, Felix & Manzur, Meher, 2017. "Nonlinear dependence in exchange rate returns: How do emerging Asian currencies compare with major currencies?," Journal of Asian Economics, Elsevier, vol. 50(C), pages 62-72.

    More about this item

    Keywords

    Real exchange rates ; unit root test ; ESTAR ; Markov Switching ; PPP;
    All these keywords.

    JEL classification:

    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • F31 - International Economics - - International Finance - - - Foreign Exchange

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:rug:rugwps:10/667. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Nathalie Verhaeghe (email available below). General contact details of provider: https://edirc.repec.org/data/ferugbe.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.