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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
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Handle: RePEc:ecb:ecbwps:20060682
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  1. Christopher F. Baum & Mustafa Caglayan & John Barkoulas, 1998. "Nonlinear Adjustment to Purchasing Power Parity in the post-Bretton Woods Era," Boston College Working Papers in Economics 404., Boston College Department of Economics, revised 16 Nov 1999.
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  8. Clostermann, Jörg & Schnatz, Bernd, 2000. "The determinants of the euro-dollar exchange rate: synthetic fundamentals and a non-existing currency," Discussion Paper Series 1: Economic Studies 2000,02, Deutsche Bundesbank, Research Centre.
  9. Christian Ewerhart & Nuno Cassola & Natacha Valla, 2007. "Declining Valuations And Equilibrium Bidding In Central Bank Refinancing Operations," Swiss Finance Institute Research Paper Series 07-22, Swiss Finance Institute.
  10. Christoph Fischer & Daniel Porath, 2010. "A reappraisal of the evidence on PPP: a systematic investigation into MA roots in panel unit root tests and their implications," Empirical Economics, Springer, vol. 39(3), pages 767-792, December.
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  12. Engel, C., 1996. "Long-Run PPP May Not Hold After All," Working Papers 96-05, University of Washington, Department of Economics.
  13. Maeso-Fernandez, Francisco & Osbat, Chiara & Schnatz, Bernd, 2001. "Determinants of the euro real effective exchange rate: a BEER/PEER approach," Working Paper Series 0085, European Central Bank.
  14. Enrique Alberola & Susana G. Cervero & Humberto Lopez & Angel Ubide, 2000. "Global Equilibrium Exchange Rates: Euro, Dollar, "Ins," "Outs," and Other Major Currencies in a Panel Cointegration Framework," Econometric Society World Congress 2000 Contributed Papers 0051, Econometric Society.
  15. Beck, Günter W. & Hubrich, Kirstin & Marcellino, Massimiliano, 2006. "Regional inflation dynamics within and across euro area countries and a comparison with the US," Working Paper Series 0681, European Central Bank.
  16. Stefan Reitz & M.P Taylor, 2006. "The Coordination Channel of Foreign Exchange Intervention," Computing in Economics and Finance 2006 16, Society for Computational Economics.
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  18. Claeys, Sophie & Hainz, Christa, 2006. "Acquisition versus greenfield: the impact of the mode of foreign bank entry on information and bank lending rates," Working Paper Series 0653, European Central Bank.
  19. Kenneth Rogoff, 1996. "The Purchasing Power Parity Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 647-668, June.
  20. Ernst, Ekkehard & Gong, Gang & Semmler, Willi & Bukeviciute, Lina, 2006. "Quantifying the impact of structural reforms," Working Paper Series 0666, European Central Bank.
  21. Sarno, Lucio & Taylor, Mark P, 1997. "The Behaviour of Real Exchange Rates During the Post-Bretton Woods Period," CEPR Discussion Papers 1730, C.E.P.R. Discussion Papers.
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  23. Eleftheriou, Maria & Gerdesmeier, Dieter & Roffia, Barbara, 2006. "Monetary policy rules in the pre-EMU era: Is there a common rule?," Working Paper Series 0659, European Central Bank.
  24. Paya, Ivan & Peel, David A., 2006. "On the speed of adjustment in ESTAR models when allowance is made for bias in estimation," Economics Letters, Elsevier, vol. 90(2), pages 272-277, February.
  25. Castrén, Olli & Fitzpatrick, Trevor & Sydow, Matthias, 2006. "What drives EU banks’ stock returns? Bank-level evidence using the dynamic dividend-discount model," Working Paper Series 0677, European Central Bank.
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