Premium
Nonlinear Mean‐Reversion in Real Exchange Rates: Toward a Solution To the Purchasing Power Parity Puzzles
Author(s) -
Taylor Mark P.,
Peel David A.,
Sarno Lucio
Publication year - 2001
Publication title -
international economic review
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 2.658
H-Index - 86
eISSN - 1468-2354
pISSN - 0020-6598
DOI - 10.1111/1468-2354.00144
Subject(s) - purchasing power parity , mean reversion , univariate , economics , monte carlo method , unit root , econometrics , exchange rate , relative purchasing power parity , arbitrage , liberian dollar , statistics , multivariate statistics , mathematics , financial economics , monetary economics , finance
We fit nonlinearly mean‐reverting models to real dollar exchange rates over the post‐Bretton Woods period, consistent with a theoretical literature on transactions 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.