Nonlinearities in Exchange-Rate Dynamics: Evidence from Five Currencies, 1973–94

Although exchange rates appear to follow a random walk when tested against linear alternatives, the null hypothesis of a random walk is rejected against a cubic alternative which embodies the intuition that the rate of mean-reversion increases with distance from equilibrium. A possible theoretical foundation for such a model is suggested. The model is tested on bilateral real exchange rates between four major currencies, and on the real effective exchange rate of these four plus the Australian dollar. The cubic model consistently outperforms its linear counterpart and the results imply that real exchange rates are in fact stationary.