Is Reversion to PPP in Euro Exchange Rates Non-Linear?

27 Pages Posted: 27 Oct 2006

Date Written: October 2006

Abstract

The paper tests for nonlinearities in the adjustment of the euro exchange rate towards purchasing power parity (PPP). It presents new survey based evidence consistent with non-linear patterns in euro exchange rate dynamics. Moreover, based on an exponential smooth transition auto-regressive (ESTAR-) model, it finds strong evidence that the speed of mean reversion in euro exchange rates increases non-linearly with the magnitude of the PPP deviation. Accordingly, while the euro real exchange rate can be well approximated by a random walk if PPP deviations are small, in periods of significant deviations, gravitational forces are set to take root and bring the exchange rate back towards its long-term trend. Consistent with higher euro-dollar volatility, deviations from the PPP equilibrium for this pair need to be stronger in order to reach the same adjustment intensity as for other currencies.

Keywords: Purchasing power parity, real exchange rate, non-linearities, STAR models

JEL Classification: F31

Suggested Citation

Schnatz, Bernd, Is Reversion to PPP in Euro Exchange Rates Non-Linear? (October 2006). ECB Working Paper No. 682, Available at SSRN: https://ssrn.com/abstract=931906

Bernd Schnatz (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
069-1344-6517 (Phone)

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