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What do we know about real exchange rate nonlinearities?

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  • 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.

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Bibliographic Info

Paper provided by Ghent University, Faculty of Economics and Business Administration in its series Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium with number 10/667.

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Length: 19 pages
Date of creation: Sep 2010
Date of revision:
Handle: RePEc:rug:rugwps:10/667

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Keywords: Real exchange rates ; unit root test ; ESTAR ; Markov Switching ; PPP;

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References

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  1. Christian Francq & Jean-Michel Zakoïan, 2000. "Stationarity of Multivariate Markov-Switching ARMA Models," Working Papers 2000-32, Centre de Recherche en Economie et Statistique.
  2. De Grauwe, Paul & Grimaldi, M, 2006. "Exchange rate puzzles: A tale of switching attractors," Open Access publications from Katholieke Universiteit Leuven urn:hdl:123456789/101113, Katholieke Universiteit Leuven.
  3. Charles Engel, 1994. "Can the Markov Switching Model Forecast Exchange Rates?," NBER Working Papers 4210, National Bureau of Economic Research, Inc.
  4. Kilian, Lutz & Ohanian, Lee E., 2002. "Unit Roots, Trend Breaks, And Transitory Dynamics: A Macroeconomic Perspective," Macroeconomic Dynamics, Cambridge University Press, vol. 6(05), pages 614-632, November.
  5. 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 143-54, March-Apr.
  6. 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.
  7. 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.
  8. 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.
  9. 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.
  10. Kruse, Robinson, 2008. "A new unit root test against ESTAR based on a class of modified statistics," Diskussionspapiere der Wirtschaftswissenschaftlichen Fakultät der Leibniz Universität Hannover dp-398, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
  11. 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.
  12. 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, 03.
  13. 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.
  14. Bruce E. Hansen & Mehmet Caner, 1997. "Threshold Autoregressions with a Unit Root," Boston College Working Papers in Economics 381, Boston College Department of Economics.
  15. 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.
  16. 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.
  17. 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.
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Cited by:
  1. Marcel Aloy & Mohamed Boutahar & Karine Gente & Anne Peguin-Feissolle, 2011. "Purchasing power parity and the long memory properties of real exchange rates: does one size fit all?," Working Papers halshs-00559170, HAL.
  2. Niels Haldrup & Robinson Kruse & Timo Teräsvirta & Rasmus T. Varneskov, 2012. "Unit roots, nonlinearities and structural breaks," CREATES Research Papers 2012-14, School of Economics and Management, University of Aarhus.
  3. 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.
  4. Hendrik Kaufmann & Robinson Kruse & Philipp Sibbertsen, 2012. "On tests for linearity against STAR models with deterministic trends," CREATES Research Papers 2012-20, School of Economics and Management, University of Aarhus.

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