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Explaining the persistence of deviations from PPP: a non-linear Harrod-Balassa-Samuelson effect?

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  • Michael Sager

Abstract

Researchers have long been vexed by the persistence of real exchange rate deviations from linear-form PPP. Two of the more popular explanations involve the role of supply shocks to the exchange rate, for instance as captured by the Harrod-Balassa-Samuelson (HBS) hypothesis that emphasizes the role of intra-economy productivity differentials, and non-linear adjustment dynamics reflecting, inter alia, non-trivial transaction costs and investor heterogeneity within the foreign exchange market. hese explanations are typically considered in isolation of one another. By contrast, this study explores whether a non-linear model that incorporates the HBS effect, as well as Terms of Trade shocks, can account for the persistence of deviations from PPP. Using quarterly data for three major exchange rates, it concludes in favour of a significant explanatory role for both variables within linear VECMs and non-linear ESTAR models. However, no strong evidence is found to suggest that these ESTAR models encompass their linear alternatives, implying that the economic benefit of modelling PPP deviations as a non-linear process is limited once account has been made of relevant supply shocks.

Suggested Citation

  • Michael Sager, 2006. "Explaining the persistence of deviations from PPP: a non-linear Harrod-Balassa-Samuelson effect?," Applied Financial Economics, Taylor & Francis Journals, vol. 16(1-2), pages 41-61.
    • Handle: RePEc:taf:apfiec:v:16:y:2006:i:1-2:p:41-61
    DOI: 10.1080/09603100500390489
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    2. Tuomas A. Peltonen & Adina Popescu & Michael Sager, 2011. "Can non‐linear real shocks explain the persistence of PPP exchange rate disequilibria?," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 16(3), pages 290-306, July.
    3. Astorga, Pablo, 2012. "Mean reversion in long-horizon real exchange rates: Evidence from Latin America," Journal of International Money and Finance, Elsevier, vol. 31(6), pages 1529-1550.
    4. Samira Haddou, 2011. "Is Tunisian Real Effective Exchange Rate Mean Reverting? Evidence from Nonlinear Models," Transition Studies Review, Springer;Central Eastern European University Network (CEEUN), vol. 18(1), pages 164-178, September.
    5. Kyttack Hong & Dong-Hwan Oh, 2009. "Non-Linear Adjustment Process In Won/Dollar And Won/Yen Real Exchage Rates," Journal of Economic Development, Chung-Ang Unviersity, Department of Economics, vol. 34(2), pages 111-130, December.

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