Evidence of non-linearities in the bilateral real exchange rates of the British pound

Abstract

Using the UK as the base country, this study investigates the nature of the inherent non-stationarity of the major bilateral real exchange rates for the post Bretton Woods era. Non-linearity is shown to be pervasive in both the changes in the real exchange rates and the residuals of the ADF model. The study proposes that misalignments of nominal exchange rates may work as signals in the export market and the financial market. The study, intuitively, argues that the dynamic motions of misalignments cause confusion to exporters as they take it as price changing positions by their foreign competitors, to the extent that exporters find it easier in some situations to resort to habits or routines in setting up their international prices rather than to attempts at optimization to reach a Stackelberg price position. The study uses a non-linear three-regime SETAR model as a parsimonious representation of this asymmetric pricing behaviour. Fluctuations in a bilateral real exchange rate, in excess and beyond fluctuations in relative prices, which give rise to non-linearity in the second moment of real exchange rate, are attributed to the dynamic motions of speculation on the nominal exchange rate in the financial market triggered continuously by signals of misalignments. This non-linearity is proved to be non-detectable but a second-generation SETAR-IGARCH model seems to be capable of capturing this type of non-linearity, implying that signals in the financial market are fully anticipated by rational agents.