DP2658 Nonlinear Mean-Reversion in Real Exchange Rates: Towards a Solution to the Purchasing Power Parity Puzzles

Author(s):	David Peel, Lucio Sarno, Mark P Taylor
Publication Date:	January 2001
Keyword(s):	Nonlinear Dynamics, Purchasing Power Parity, Real Exchange Rate, Test Power, Unit Root Test
JEL(s):	C10, F31, F41
Programme Areas:	International Macroeconomics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=2658

We fit nonlinearly mean-reverting models to real dollar exchange rates over the post-Bretton Woods period, consistent with a theoretical literature on transaction costs in international arbitrage. The half lives of real exchange rate shocks, calculated through Monte Carlo integration, imply faster adjustment speeds than hitherto recorded. Monte Carlo simulations reconcile our results with the large empirical literature on unit roots in real exchange rates by showing that when the real exchange rate is nonlinearly mean reverting, standard univariate unit root tests have low power, while multivariate tests have much higher power to reject a false null hypothesis