What Do We Know About Real Exchange Rate Non-Linearities?
CREATES Research Paper 2009-50
27 Pages Posted: 29 Oct 2009
Date Written: October 28, 2009
This research points to the serious problem of potentially misspecified alternative hypotheses when testing for unit roots in real exchange rates. We apply a popular unit root test against nonlinear ESTAR and develop a Markov Switching unit root test. The empirical power of these tests against correctly and misspecified non-linear alternatives is analyzed by means of a Monte Carlo study. The chosen parametrization is obtained by real-life exchange rates. The test against ESTAR has low power against all alternatives whereas the proposed unit root test against a Markov Switching autoregressive model performs clearly better. An empirical application of these tests suggests that real exchange rates may indeed be explained by Markov-Switching dynamics.
Keywords: real exchange rates, unit root test, ESTAR, Markov Switching, PPP
JEL Classification: C12, C22, F31
Suggested Citation: Suggested Citation