Nonlinear adjustment in PPP—evidence from threshold cointegration

Abstract

Nonlinearity in PPP has been carefully reported in number of studies. However, asymmetry with respect to the sign of the deviation and the dependency of the asymmetry on the exchange rate regime has largely remained outside the scope of those studies. The present paper partly fills this gap. It applies threshold cointegration techniques to real exchange rate dynamics between two Nordic countries, Finland and Sweden. First, it examines whether the sign of the deviation from equilibrium has any impact on adjustment. Second, it estimates an asymmetric band-type threshold cointegration in PPP. The results supported asymmetric adjustment in PPP. The single, asymmetric threshold indicated stronger adjustment during the flexible exchange rate regime. The band-type asymmetric threshold cointegration suggested that adjustment towards PPP would be fastest within the estimated band, which was interpreted as evidence for the target zone exchange rate regime. Accordingly, the inference on adjustment is sensitive to the type of nonlinearity used.