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): Unit Root Test , Test Power , Purchasing Power Parity , Real Exchange Rate , Nonlinear Dynamics

JEL(s): C10 , F31 , F41

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP2658.asp

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