Working Paper: CEPR ID: DP2658
Authors: Mark P. Taylor; David A. Peel; Lucio Sarno
Abstract: 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
Keywords: nonlinear dynamics; purchasing power parity; real exchange rate; test power; unit root test
JEL Codes: C10; F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| size of the deviation (C46) | speed of adjustment back to equilibrium (D50) |
| nonlinear mean reversion (C22) | faster adjustment process (F32) |
| statistical method used (C29) | ability to detect mean reversion (C22) |
| transaction costs and arbitrage opportunities (F12) | dynamics of real exchange rates (F31) |