Bayesian Analysis of Nonlinear Exchange Rate Dynamics and the Purchasing Power Parity Persistence Puzzle

39 Pages Posted: 15 Apr 2013

See all articles by Ming Chien Lo

Ming Chien Lo

Saint Cloud State University - Department of Economics

James Morley

University of Sydney

Date Written: April 2013

Abstract

We investigate the persistence of real exchange rates using Bayesian methods. First, an algorithm for Bayesian estimation of nonlinear threshold models is developed. Unlike standard grid-based estimation, the Bayesian approach fully captures joint parameter uncertainty and uncertainty about complicated functions of the parameters, such as the half-life measure of persistence based on generalized impulse response functions. Second, model comparison is conducted via marginal likelihoods, which reflect the relative abilities of models to predict the data given prior beliefs about model parameters. This comparison is conducted for a range of linear and nonlinear models and provides a direct evaluation of the importance of nonlinear dynamics in modeling exchange rates. The marginal likelihoods also imply weights for a model-averaged measure of persistence. The empirical results for real exchange rate data from the G7 countries suggest general support for nonlinearity, but the strength of the evidence depends on which country pair is considered. However, the model-averaged estimates of half-lives are uniformly smaller than for the linear models alone, suggesting that the purchasing power parity persistence puzzle is less of a puzzle than previously thought.

Keywords: Bayesian Analysis, Real Exchange Rate Dynamics, Purchasing Power Parity, Nonlinear Threshold Models, Bayesian Model Averaging, Half lives

JEL Classification: C11, C22, F31

Suggested Citation

Lo, Ming Chien and Morley, James, Bayesian Analysis of Nonlinear Exchange Rate Dynamics and the Purchasing Power Parity Persistence Puzzle (April 2013). UNSW Australian School of Business Research Paper No. 2013-05. Available at SSRN: https://ssrn.com/abstract=2250905 or http://dx.doi.org/10.2139/ssrn.2250905

Ming Chien Lo (Contact Author)

Saint Cloud State University - Department of Economics ( email )

720 Fourth Avenue South
St. Cloud, MN 56301-4498
United States
320-308-0143 (Phone)
320-308-2228 (Fax)

James Morley

University of Sydney ( email )

Rm 370 Merewether (H04)
Sydney, NSW 2006 2008
Australia

HOME PAGE: http://https://sites.google.com/site/jamescmorley/

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