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Is reversion to PPP in euro exchange rates non-linear?

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  • Schnatz, Bernd

Abstract

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

Suggested Citation

  • Schnatz, Bernd, 2006. "Is reversion to PPP in euro exchange rates non-linear?," Working Paper Series 682, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:2006682
    Note: 231394
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    File URL: https://www.ecb.europa.eu//pub/pdf/scpwps/ecbwp682.pdf
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    Cited by:

    1. Derek Bond & Michael Harrison & Edward O'Brien, 2011. "Nonlinearity and structural breaks in Irish PPP relationships: an application of random field regression," Applied Economics, Taylor & Francis Journals, vol. 43(15), pages 1899-1911.
    2. Luke Willard, 2007. "Trade Costs and Some Puzzles in International Macroeconomics," RBA Research Discussion Papers rdp2007-10, Reserve Bank of Australia.

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    More about this item

    Keywords

    non-linearities; purchasing power parity; real exchange rate; STAR models;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange

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