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

  • Schnatz, Bernd

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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Paper provided by European Central Bank in its series Working Paper Series with number 0682.

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