Real Exchange Rate, Stationarity, and Economic Fundamentals

By Kanas, Angelos | Journal of Economics and Finance, October 2009 | Go to article overview

Real Exchange Rate, Stationarity, and Economic Fundamentals


Kanas, Angelos, Journal of Economics and Finance


Abstract

Using monthly data for the US/UK real exchange rate over the period 1921-2002, we find evidence that the mean reverting tendency of the real exchange rate is stochastic, and regime-dependent. There is one regime over which PPP holds as a long-run equilibrium relation, i.e. a stationary PPP regime, and another regime over which PPP does not hold, i.e. a non-stationary PPP regime. The transition from the non-stationary to the stationary regime is found to be affected by the real interest rate differential, and by the volatility of the nominal exchange rate. The real output differential does not appear to affect the transition probability.

Keywords PPP * Regime Switching, Real Interest Rate Differential, Real Output Differential

JEL Classification F31 * C22 * F41

1 Introduction

This paper examines the issue of whether the US/UK real exchange rate is stationary or not, using a new econometric framework and monthly data over the period 1921-2002. We consider an extension of the Augmented Dickey Fuller (ADF) test which allows for stochastic switching across regimes; switching is allowed to depend on theory-implied economic fundamental variables such as the real interest rate differential, the real output differential, and the volatility of the nominal exchange rate. We find strong evidence of stochastic switching across two regimes, and regime (non)stationarity: one regime corresponds to epochs during which the real exchange rate is stationary and PPP holds as a long-run equilibrium theory, which we refer to as the 'stationary' or the 'equilibrium' regime. The other regime corresponds to epochs during which the real exchange rate is non-stationary and PPP does not hold, which we refer to as the 'non-stationary' or 'disequilibrium' regime. The probability of transition from the disequilibrium to the equilibrium regime is found to be dependent upon the real interest rate differential and the volatility of the nominal exchange rate, whilst the real output differential does not affect the transition probability. The results indicate that the US/UK real exchange rate is characterized by a stochastic unit root: its dynamics are different across different periods and switch stochastically from a stationary process to a random walk process. This is in line with Genberg (1978), Edison (1987), and Engel and Kim (2001) who argued that the data generation process for the US/UK real exchange rate may be changing over time. Furthermore, this finding may explain the sample-dependence in the results of empirical studies on the US/UK real exchange rate and thus, bridge the gap between studies which found evidence of stationarity and other studies which found evidence of non-stationarity over different sample periods (Lothian and Taylor 1996; Glen 1992; Adler and Lehmann 1983; Corbae and Ouliaris 1991). The result that the nominal exchange rate volatility is significant in affecting the probability of this switch is in line with the literature suggesting that PPP may hold better during periods characterized by fixed or pegged (less volatile) exchange rates (Genberg 1978; Bleaney et al. 1999; McNown and Wallace 1989; Liu 1992). The finding that the real interest rate differential is also important in the transition probability is in line with Dumas (1992), and implies that it should be considered as a determinant variable of the data generation process of the real exchange rate.

With regard to the theoretical literature on PPP, this paper belongs to the strand of literature suggesting that the real exchange rate dynamics should be modeled within a multivariate, rather than a univariate, framework by incorporating economic fundamentals (Goswami et al. 2004). Dumas (1992), using a general equilibrium real/financial model, concluded that the expected real exchange rate change depends on the real interest rate differential. An alternative theoretical approach, which explains the real exchange rate behavior in terms of the real interest rate differential, emphasized monetary aspects and sticky prices (Domsbusch 1976; Frenkel 1976).

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