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Further empirical evidence on the consumption-real exchange rate anomaly

Author

Listed:
  • Efthymios Pavlidis
  • Ivan Paya
  • David Peel

Abstract

This paper adopts a nonlinear framework to model the deviations of the real exchange rate from its fundamental value implied by International Real Business Cycle models with complete asset markets. By focusing on the post Bretton Woods era, we find that in several cases there is a long run relationship between real exchange rates and consumption series in line with international risk sharing. Further, linearity tests indicate that the majority of the deviation processes exhibit significant smooth transition nonlinearity. Exponential Smooth Transition Autoregressive models appear parsimoniously to capture the nonlinear adjustment. These findings provide an explanation for the empirical regularities noted in the literature on the relation between the real exchange rate and consumption, such as the Backus and Smith (1993) puzzle. Finally, Generalized Impulse Response functions show that shock absorption is significantly faster than suggested in the Purchasing Power Parity puzzle.

Suggested Citation

  • Efthymios Pavlidis & Ivan Paya & David Peel, 2010. "Further empirical evidence on the consumption-real exchange rate anomaly," Working Papers 447022, Lancaster University Management School, Economics Department.
  • Handle: RePEc:lan:wpaper:447022
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