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Bayesian Analysis of Nonlinear Exchange Rate Dynamics and the Purchasing Power Parity Persistence Puzzle

  • Ming Chien Lo


    (Department of Economics, St. Cloud State University)

  • James Morley


    (School of Economics, the University of New South Wales)

We investigate the persistence of real exchange rates using Bayesian methods. First, an algorithm for Bayesian estimation of nonlinear threshold models is developed. Unlike standard grid-based estimation, the Bayesian approach fully captures joint parameter uncertainty and uncertainty about complicated functions of the parameters, such as the half-life measure of persistence based on generalized impulse response functions. Second, model comparison is conducted via marginal likelihoods, which reflect the relative abilities of models to predict the data given prior beliefs about model parameters. This comparison is conducted for a range of linear and nonlinear models and provides a direct evaluation of the importance of nonlinear dynamics in modeling exchange rates. The marginal likelihoods also imply weights for a modelaveraged measure of persistence. The empirical results for real exchange rate data from the G7 countries suggest general support for nonlinearity, but the strength of the evidence depends on which country pair is considered. However, the model-averaged estimates of half-lives are uniformly smaller than for the linear models alone, suggesting that the purchasing power parity persistence puzzle is less of a puzzle than previously thought.

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Paper provided by School of Economics, The University of New South Wales in its series Discussion Papers with number 2013-05.

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Length: 39 pages
Date of creation: May 2013
Date of revision:
Handle: RePEc:swe:wpaper:2013-05
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  1. Lothian, James R & Taylor, Mark P, 1996. "Real Exchange Rate Behavior: The Recent Float from the Perspective of the Past Two Centuries," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 488-509, June.
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  16. Frédérique Bec & Mélika Ben Salem & Marine Carrasco, 2009. "Detecting Mean Reversion in Real Exchange Rates from a Multiple Regime STAR Model," CIRANO Working Papers 2009s-18, CIRANO.
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