Skip to main content
×
Home
    • Aa
    • Aa

A NONLINEAR ANALYSIS OF THE REAL EXCHANGE RATE–CONSUMPTION RELATIONSHIP

  • Efthymios G. Pavlidis (a1), Ivan Paya (a1) and David A. Peel (a1)
Abstract

A variety of international macroeconomic models predict a relationship between the real exchange rate and consumption. The empirical evidence in favor of such a relationship is limited, the so-called Backus and Smith puzzle. In this paper, we extend the analysis to allow for nonlinear dynamics and volatility changes across exchange rate regimes. Our findings suggest that long-run relationships in line with standard international business cycle models do exist for many Organization for Economic Co-operation and Development (OECD) countries. Further, Monte Carlo experiments illustrate that the nonlinear models can generate the Backus and Smith and the exchange rate disconnect puzzles. In this paper, we also contribute to the nonlinear real exchange rate literature by establishing a theoretical relationship between volatility and persistence. In accordance with the theoretical results, our empirical findings suggest that the increase in volatility in the post-Bretton Woods era is associated with relatively fast mean reversion of the real rate toward its equilibrium value.

Copyright
Corresponding author
Address correspondence to: Ivan Paya, Department of Economics, Lancaster University Management School, Lancaster LA1 4YX, UK; e-mail: i.paya@lancaster.ac.uk.
Footnotes
Hide All

We are grateful to participants of the 2nd International Workshop on Financial Markets and Nonlinear Dynamics for useful comments and suggestions. Documentation about the data used in this paper is available from the Lancaster University data archive at http://dx.doi.org/10.17635/lancaster/researchdata/84.

Footnotes
Linked references
Hide All

This list contains references from the content that can be linked to their source. For a full set of references and notes please see the PDF or HTML where available.

David K. Backus and Gregor W. Smith (1993) Consumption and real exchange rates in dynamic economies with non-traded goods. Journal of International Economics 35 (3), 297316.

Béla Balassa (1964) The purchasing power parity doctrine: A reappraisal. Journal of Political Economy 72 (6), 584596.

Gianluca Benigno and Christoph Thoenissen (2008) Consumption and real exchange rates with incomplete markets and non-traded goods. Journal of International Money and Finance 27 (6), 926948.

Matilde Bombardini and Francesco Trebbi (2012) Risk aversion and expected utility theory: An experiment with large and small stakes. Journal of the European Economic Association 10 (6), 13481399.

Varadarajan V. Chari , Patrick J. Kehoe , and Ellen R. McGrattan (2002) Can sticky price models generate volatile and persistent real exchange rates? Review of Economic Studies 69 (6), 533563.

Raj Chetty (2006) A new method of estimating risk aversion. American Economic Review 96 (5), 18211834.

Alexandre Dmitriev and Ivo Krznar (2012) Habit persistence and international comovements. Macroeconomic Dynamics 16 (S3), 312330.

Bernard Dumas (1992) Dynamic equilibrium and the real exchange rate in a spatially separated world. Review of Financial Studies 5 (2), 153180.

Allen C. Head , Todd D. Mattina , and Gregor W. Smith (2004) Real exchange rates, preferences, and incomplete markets: Evidence, 1961–2001. Canadian Journal of Economics 37 (3), 782801.

Søren Johansen (1991) Estimation and hypothesis testing of cointegration vectors in Gaussian vector autoregressive models. Econometrica 59 (6), 15511580.

Robert G. King , Charles I. Plosser , and Sergio T. Rebelo (1988) Production, growth and business cycles, I. The basic neoclassical model. Journal of Monetary Economcis 21 (2), 195232.

Robert Kollmann (1995) Consumption, real exchange rates and the structure of international asset markets. Journal of International Money and Finance 14 (2), 191211.

Robert Kollmann (2012) Limited asset market participation and the consumption-real exchange rate anomaly. Canadian Journal of Economics 45 (2), 566584.

Gary Koop , M. Hashem Pesaran , and Simon M. Potter (1996) Impulse response analysis in nonlinear multivariate models. Journal of Econometrics 74 (1), 119147.

Richard Layard , Guy Mayraz , and Stephen Nickell (2008) The marginal utility of income. Journal of Public Economics 92 (8), 18461857.

Nan Li (2014) Transaction costs, nonfundamental uncertainty, and the exchange rate disconnect. Macroeconomic Dynamics 18 (08), 17511772.

James R. Lothian and Mark P. Taylor (2008) Real exchange rates over the past two centuries: How important is the Harrod-Balassa-Samuelson effect? Economic Journal 118 (532), 17421763.

Panos Michael , A. Robert Nobay , and David A. Peel (1997) Transactions costs and nonlinear adjustment in real exchange rates: An empirical investigation. Journal of Political Economy 105 (4), 862879.

Michael L. Mussa (1986) Nominal exchange rate regimes and the behaviour of real exchange rates: Evidence and implications. Carnegie-Rochester Conference Series on Public Policy 25, 117214.

Efthymios G. Pavlidis , Ivan Paya , and David A. Peel (2015) Testing for linear and nonlinear Granger causality in the real exchange rate–consumption relation. Economics Letters 132, 1317.

Ivan Paya and David A. Peel (2006) A new analysis of the determinants of the real dollar-sterling exchange rate: 1871–1994. Journal of Money, Credit and Banking 38 (8), 19711990.

Paul Samuelson (1964) Theoretical notes on trade problems. Review of Economics and Statistics 46 (2), 145154.

Mark P. Taylor , David A. Peel , and Lucio Sarno (2001) Nonlinear mean-reversion in real exchange rates: toward a solution to the purchasing power parity puzzles. International Economic Review 42 (4), 10151042.

Timo Teräsvirta (1994) Specification, Estimation, and evaluation of smooth transition autoregressive models. Journal of the American Statistical Association 89 (425), 208218.

Tatsuma Wada (2014) The role of transitory and persistent shocks in the consumption correlation and international comovement puzzles. Macroeconomic Dynamics 18 (6), 12341270.

Recommend this journal

Email your librarian or administrator to recommend adding this journal to your organisation's collection.

Macroeconomic Dynamics
  • ISSN: 1365-1005
  • EISSN: 1469-8056
  • URL: /core/journals/macroeconomic-dynamics
Please enter your name
Please enter a valid email address
Who would you like to send this to? *
×

Keywords:

Metrics

Full text views

Total number of HTML views: 0
Total number of PDF views: 9 *
Loading metrics...

Abstract views

Total abstract views: 27 *
Loading metrics...

* Views captured on Cambridge Core between 11th July 2017 - 27th July 2017. This data will be updated every 24 hours.