PPP may hold better than you think: Smooth breaks and non-linear mean reversion in real effective exchange rates

This paper revisits some key topics in the literature on purchasing power parity (PPP). The study applies a set of newly developed unit root tests, which account for both nonlinearity and multiple smooth temporary breaks in series, to the real effective exchange rates (REERs) of 23 developed countries. The results suggest that PPP generally holds for various currency-based real rates. There is evidence in favor of linear stationarity in REERs for highly integrated economies. The REERs of most other countries tend to have nonlinear adjustment toward large long-swing type mean changes around constant equilibrium values.     

Evidence on purchasing power parity from univariate models: the case of smooth transition trend‐stationarity

Recent research has found that trend‐break unit root tests derived from univariate linear models do not support the hypothesis of long‐run purchasing power parity (PPP) for US dollar real exchange rates. In this paper univariate smooth transition models are utilized to develop unit root tests that allow under the alternative hypothesis for stationarity around a gradually changing deterministic trend function. These tests reveal statistically significant evidence against the null hypothesis of a unit root for the real exchange rates of a number of countries against the US dollar. However, restrictions consistent with long‐run PPP are rejected for some of the countries for which a rejection of the unit root hypothesis is obtained. Copyright © 2005 John Wiley & Sons, Ltd.     

The Yen Real Exchange Rate may be Stationary after all: Evidence from Non‐linear Unit‐root Tests*

The empirical literature that tests for purchasing power parity (PPP) by focusing on the stationarity of real exchange rates has so far provided, at best, mixed results. The behaviour of the yen real exchange rate has most stubbornly challenged the PPP hypothesis and deepened this puzzle. This paper contributes to this discussion by providing new evidence on the stationarity of bilateral yen real exchange rates. We employ a non‐linear version of the augmented Dickey–Fuller test, based on an exponentially smooth‐transition autoregressive model (ESTAR) that enhances the power of the tests against mean‐reverting non‐linear alternative hypotheses. Our results suggest that the bilateral yen real exchange rates against the other G7 and Asian currencies were mean reverting during the post‐Bretton Woods era. Thus, the real yen behaviour may not be so different after all but simply perceived to be so because of the use of a restrictive alternative hypothesis in previous tests.     

Long‐term rates: lower for longer

With the Federal Reserve and other central banks likely to start raising interest rates from next year, the focus is now on how high interest rates might ultimately go. Long‐term analysis of the path of interest rates in the world's main economies suggests that interest rates tend over time to gravitate towards a level reflecting long‐run growth and inflation. But there is scope for real interest rates to depart substantially from growth for lengthy periods of time. Based on our long‐run forecasts for growth and inflation we take the view that long‐term interest rates are likely to settle in at levels a bit lower than their recent historic averages. Structural changes in the world economy and vulnerabilities in the advanced economies are also likely to slow the process by which long‐term rates rise from current levels to their steady state positions. OE forecasts for long‐term rates in the major economies are generally lower at the 1‐year and long‐term horizons than consensus.     

On the Empirical Failure of Purchasing Power Parity Tests

Empirical research on the validity of the purchasing power parity (PPP) condition is generally based on real exchange rates built using the consumer price index (CPI), but fails to provide clear support to PPP. In this paper we show theoretically that, even if the law of one price (LOP) holds for traded goods, CPI‐based real exchange rates are not mean reverting, and are neither stationary nor integrated. Therefore, both unit root and stationarity tests should reject their null. Our theoretical results are validated both by simulations and an empirical application. Copyright © 2014 John Wiley & Sons, Ltd.     

The demand for M3 in the euro area

In this paper, an empirically stable money demand model for M3 in the euro area is constructed. Starting with a multivariate system, three cointegrating relationships with economic content are found: (i) the spread between the long‐term and the short‐term nominal interest rates, (ii) the long‐term real interest rate, and (iii) a long‐run demand for broad money M3. There is evidence that the determinants of M3 money demand are weakly exogenous with respect to the long‐run parameters. Hence, following a general‐to‐specific modelling approach, a parsimonious conditional error‐correction model for M3 money demand is derived which can be interpreted economically. For the conditional model, long‐run and short‐run parameter stability is extensively tested and not rejected. Copyright © 2001 John Wiley & Sons, Ltd.     

Further Evidence on PPP Adjustment Speeds: the Case of Effective Real Exchange Rates and the EMS*

Two different approaches intend to resolve the ‘puzzling’ slow convergence to purchasing power parity (PPP) reported in the literature [see Rogoff (1996) , Journal of Economic Literature, Vol. 34.] On the one hand, there are models that consider a non‐linear adjustment of real exchange rate to PPP induced by transaction costs. Such costs imply the presence of a certain transaction band where adjustment is too costly to be undertaken. On the other hand, there are models that relax the ‘classical’ PPP assumption of constant equilibrium real exchange rates. A prominent theory put together by Balassa (1964, Journal of Political Economy, Vol. 72) and Samuelson (1964 Review of Economics and Statistics, Vol. 46) , the BS effect, suggests that a non‐constant real exchange rate equilibrium is induced by different productivity growth rates between countries. This paper reconciles those two approaches by considering an exponential smooth transition‐in‐deviation non‐linear adjustment mechanism towards non‐constant equilibrium real exchange rates within the EMS (European Monetary System) and effective rates. The equilibrium is proxied, in a theoretically appealing manner, using deterministic trends and the relative price of non‐tradables to proxy for BS effects. The empirical results provide further support for the hypothesis that real exchange rates are well described by symmetric, nonlinear processes. Furthermore, the half‐life of shocks in such models is found to be dramatically shorter than that obtained in linear models.     

Real exchange rate,stationarity, and economic fundamentals

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.     

An examination of the forward prediction error of U.S. dollar exchange rates and how they are related to bid-ask spreads,purchasing power parity disequilibria,and forward premium asymmetry

Using a panel data approach, we find statistically significant evidence that bid-ask spreads and deviations from purchasing power parity (PPP) are related to the forward prediction error of ten major U.S. dollar exchange rates over the post Plaza Accord period. Previous literature suggests that bid-ask spreads proxy for liquidity risk and deviations from PPP are a source of time-varying risk premiums. Additionally, the paper provides evidence that the forward discount bias is asymmetric with respect to the sign of the forward premium as well as to an undervalued and overvalued U.S. dollar.     

Disaggregate productivity comparisons: sectoral convergence in OECD countries

International comparisons of productivity have used exchange rates or purchasing power parity (PPP) to make output comparable across countries. While aggregate PPP holds well in the long run, sectoral deviations are persistent. It raises the need for a currency conversion factor at the same level of aggregation as the output that is compared. Mapping prices from household expenditure surveys into the industrial classification of sectors and adjusting for taxes and international trade, I obtain an expenditure-based sector-specific PPP. Using detailed price data for up to 8 years between 1970 and 1999, I test whether the sectoral PPPs adequately capture differential changes in relative prices between countries. They work well for agriculture and the majority of industrial sectors, but not for most service sectors and for manufacturing sectors that produce differentiated products. Using the most appropriate conversion factor for each industry, productivity convergence is found to be taking place in all but a few industries for a group of 14 OECD countries. The latter results are robust to the base year used for the currency conversion.     

PHILLIPS CURVES AND UNEMPLOYMENT DYNAMICS: A CRITIQUE AND A HOLISTIC PERSPECTIVE

Abstract.  The conventional wisdom that inflation and unemployment are unrelated in the long run implies the compartmentalization of macroeconomics. While one branch of the literature models inflation dynamics and estimates the unemployment rate compatible with inflation stability, another one determines the real economic factors that drive the natural rate of unemployment. In the context of the new Phillips curve, we show that frictional growth, i.e. the interplay between lags and growth, generates an inflation–unemployment trade-off in the long run. We thus argue that a holistic framework, such as the chain reaction theory (CRT), should be used to jointly explain the evolution of inflation and unemployment. A further attraction of the CRT approach is that it provides a synthesis of the traditional structural macroeconometric models and the (structural) vector autoregressions.     

Housing, credit, and real activity cycles: Characteristics and comovement

This paper describes the characteristics and comovement of cycles in house prices, residential investment, credit, interest rates, and real activity in advanced economies during the past 25 years. Stylized facts and regularities are uncovered using a dynamic generalized factor model and spectral techniques. House price cycles are found to lead credit and real activity over the long term, while in the short to medium term the relationship varies across countries. Interest rates tend to lag other cycles at all time horizons. Although global factors are important, the US business cycle, housing cycle and interest rate cycle generally lead the respective cycles in other countries over all time horizons, while the US credit cycle leads mainly over the long term.     

Valuation ratios and long‐horizon stock price predictability

Using annual data for 1872–1997, this paper re‐examines the predictability of real stock prices based on price–dividend and price–earnings ratios. In line with the extant literature, we find significant evidence of increased long‐horizon predictability; that is, the hypothesis that the current value of a valuation ratio is uncorrelated with future stock price changes cannot be rejected at short horizons but can be rejected at longer horizons based on bootstrapped critical values constructed from linear representations of the data. While increased statistical power at long horizons in finite samples provides a possible explanation for the pattern of predictability in the data, we find via Monte Carlo simulations that the power to detect predictability in finite samples does not increase at long horizons in a linear framework. An alternative explanation for the pattern of predictability in the data is nonlinearities in the underlying data‐generating process. We consider exponential smooth‐transition autoregressive models of the price–dividend and price–earnings ratios and their ability to explain the pattern of stock price predictability in the data. Copyright © 2005 John Wiley & Sons, Ltd.     

Can we identify Balassa-Samuelson effects with measures of product variety?

The Balassa-Samuelson hypothesis - i.e. that real exchange rates between each pair of countries increase with the tradables sector productivities ratio between these countries, and decrease with their non-tradables sector productivities ratio - has been one of the most prominent frameworks in open economy macroeconomics for more than 40 years. However, empirical studies have often been unable to confirm it. We argue that this might at least in part be due to measurement errors leading to downward-biased estimates. We test the Balassa-Samuelson hypothesis with innovative trade-based variety measures to differentiate between tradables and non-tradables sector productivities that do not suffer from such errors-in-variables. Using a pairwise regression approach, we find stable and very robust Balassa-Samuelson effects over all our specifications.     

A dynamic econometric model of agricultural wage determination in Bangladesh

Economists applied data from 1949-1950 and 1980-1981 to a new dynamic model to examine the dynamics of determinants of agricultural wages in Bangladesh, particularly the effect of changes in relative prices of rice (the staple food) and productivity. Just a 20% rise in the price or rice was passed on in the agricultural wage rate within the current year. About 50% was passed on in the long run, however. Therefore an increase in the price of rice reduced the rice purchasing power of agricultural wages in the short and long term. In fact, the importance given to rice in the long run real wage rate was almost the same as the mean proportion of expenditure that an agricultural laborer in Bangladesh committed to rice and closely related food staples. Thus arise in the price of rice in comparison to other goods had limited effects on the long run real wage in terms of the bundle of goods typically consumed, but very adverse effects in the short run placing a high burden on the rural poor. On the other hand, the long run real wage rate fell considerably between the mid 1960s-early 1980s when overall agricultural productivity increased. The economists pointed out that this increased productivity may not have lowered long run real wage rates, but instead mitigating factors may have contributed to this fall. For example, population growth, rising landlessness, and insufficient economic growth in nonagricultural sectors resulted in a consistent growth in the labor supply. In conclusion, this new dynamic model showed that Bangladesh cannot depend only on agricultural growth to reduce the poverty of farmers.     

Nonlinear dynamics of interest rate and inflation

According to several empirical studies US inflation and nominal interest rates as well as the real interest rate can be described as unit root processes. These results imply that nominal interest rates and expected inflation do not move one‐for‐one in the long run, which is incongruent with theoretical models. In this paper we introduce a new nonlinear bivariate mixture autoregressive model that seems to fit quarterly US data (1953 : II–2004 : IV) reasonably well. It is found that the three‐month Treasury bill rate and inflation share a common nonlinear component that explains a large part of their persistence. The real interest rate is devoid of this component, indicating one‐for‐one movement of the nominal interest rate and inflation in the long run and, hence, stationarity of the real interest rate. Copyright © 2006 John Wiley & Sons, Ltd.     

Forecasts of US short-term interest rates: A flexible forecast combination approach

This paper develops a flexible approach to combine forecasts of future spot rates with forecasts from time-series models or macroeconomic variables. We find empirical evidence that, accounting for both regimes in interest rate dynamics, and combining forecasts from different models, helps improve the out-of-sample forecasting performance for US short-term rates. Imposing restrictions from the expectations hypothesis on the forecasting model are found to help at long forecasting horizons.     

Testing the purchasing power parity through I(2) cointegration techniques

This paper contributes to the empirical literature on the purchasing power parity (PPP) over the post‐Bretton Woods period by providing a time‐series based interpretation of the controversial evidence characterizing the dynamics of real exchange rates. It is shown that the persistence of deviations from the PPP between a set of European countries and the United States may be empirically attributed to the presence of I(2) stochastic trends in prices using Consumer Price Indices. Interestingly, the slow adjustment towards the equilibrium can be modelled through ‘integral‐proportional’ equilibrium correction models and this evidence can be partly reconciled with theories where the inflation rate reduces the markup of profit‐maximizing firms acting on imperfectly competitive markets. Copyright © 2005 John Wiley & Sons, Ltd.     

Nonlinear adjustment,purchasing power parity and the role of nominal exchange rates and prices

Although the literature on purchasing power parity (PPP) is rich in controversy, the relative contribution of prices and nominal exchange rates to real exchange rate movements which restore PPP disequilibria has rarely been put under any close scrutiny. This paper as a first step applies a cointegrated VAR framework to test for stationary real exchange rates and linear adjustments in prices and nominal exchange rates. As a second step, ESTR error correction models are fitted to test whether nonlinear error correctional behaviour characterizes the data. The results clearly indicate that the nominal exchange rate is responsible for the nonlinear mean reverting behaviour in real exchange rates and also mainly drives overall adjustment. Applying dynamic stochastic simulations based on the estimated models, this study also confirms recent results that the half-life times of real exchange rate shocks are significantly smaller than the consensus benchmark of 3–5 years.     

Inflation and interest rate derivatives for FX risk management: Implications for exporting firms under real wealth

Firms that export goods face risks such as product price, cost, and exchange rate risks. Price and cost risks can substantially reduce the FX hedging performance in real wealth. We thus investigate hedging strategies that are intended to improve the performance of the FX hedge in real terms using inflation and interest rate derivatives. The impact of these additional instruments is not clear and has only been briefly analyzed in the hedging literature so far. For this purpose, we derive variance-minimizing hedge positions of an exporting firm. A cointegrated VAR and bootstrap methods are used to evaluate the efficiencies of several hedging strategies. While inflation derivatives work better in the short run, interest rate derivatives perform better over longer hedge horizons.