Real Exchange Rates: Heteroscedasticity and Reversion Toward PPP
Previous attempts to reject the hypothesis that real exchange rates follow a random walk have produced mixed results. This paper incorporates mean reversion and conditional heteroscedasticity into tests based on a theoretical model of deviations from the law of one price by Dumas (1988). The results indicate that once conditional heteroscedasticity is incorporated into the estimation significant mean reversion cannot be rejected. The tests also point to substantial differences between the real exchange rate behavior of countries which are in the European Monetary System and those which are not.
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