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On the relationship between nominal exchange rates and domestic and foreign prices

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  • Ivan Paya
  • David Peel

Abstract

A number of authors have found significant cointegrating relationships between spot exchange rates and domestic and foreign price levels for the major currencies where the magnitude of the coefficients makes economic interpretation of PPP cumbersome. Using theoretically well motivated nonlinear models for 'artifitially' created real exchange rates, this paper investigates the properties of two alternative cointegration procedures, namely the Johansen and Saikkonen methodologies. The latter procedure appears to outperform the former one in terms of finding the 'true' cointegrating coefficients. The new weights obtained with the Saikkonen method are then used to estimate non-linear ESTAR model for the real exchange rate. The 'new' real exchange rates exhibit, in most cases, much lower half-life shocks than the ones predicted by the Rogoff (1996) puzzle.

Suggested Citation

  • Ivan Paya & David Peel, 2007. "On the relationship between nominal exchange rates and domestic and foreign prices," Applied Financial Economics, Taylor & Francis Journals, vol. 17(2), pages 105-117.
  • Handle: RePEc:taf:apfiec:v:17:y:2007:i:2:p:105-117
    DOI: 10.1080/09603100500438809
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    Cited by:

    1. McMillan, David G., 2009. "The confusing time-series behaviour of real exchange rates: Are asymmetries important?," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 19(4), pages 692-711, October.
    2. John Beirne, 2012. "The long-run convergence of exchange rates and prices in the European Union," International Review of Applied Economics, Taylor & Francis Journals, vol. 26(3), pages 367-385, April.
    3. I Paya & D Peel, 2005. "Temporal aggregation of an ESTAR process," Working Papers 565938, Lancaster University Management School, Economics Department.
    4. 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.
    5. Grossmann, Axel & McMillan, David G., 2010. "Forecasting exchange rates: Non-linear adjustment and time-varying equilibrium," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 20(4), pages 436-450, October.

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