Nonlinearities and asymmetric adjustment to PPP in an exchange rate model with inflation expectations

Christina Anderl,Guglielmo Maria Caporale

doi:10.1108/jes-02-2021-0109

Abstract

PurposeThis paper aims to explain real exchange rate fluctuations by means of a model including both standard fundamentals and two alternative measures of inflation expectations for five inflation targeting countries (the UK, Canada, Australia, New Zealand and Sweden) over the period January 1993–July 2019.Design/methodology/approachBoth a benchmark linear autoregressive distributed lag (ARDL) model and a nonlinear autoregressive distributed lag (NARDL) specification are considered.FindingsThe results suggest that the nonlinear framework is more appropriate to capture the behaviour of real exchange rates given the presence of asymmetries both in the long and short run. In particular, the speed of adjustment towards the purchasing power parity (PPP) implied long-run equilibrium is three times faster in a nonlinear framework, which provides much stronger evidence in support of PPP. Moreover, inflation expectations play an important role, with survey-based ones having a more sizable effect than market-based ones.Originality/valueThe focus on linearities and the estimation of a NARDL model, which is shown to outperform the linear ARDL model both within sample and out of sample, is an important contribution to the existing literature which has rarely applied this type of framework; the choice of an appropriate econometric method also makes the policy implications of the analysis more reliable; in particular, monetary authorities should aim to achieve a high degree of credibility to manage them and thus currency fluctuations effectively; the inflation targeting framework might be especially appropriate for this purpose.

Highlights

The well-known purchasing power parity (PPP) puzzle (Rogoff, 1996) consists in the fact that real exchange rates appear to be more volatile and to exhibit more persistence than implied by most exchange rate determination models
It appears that, when nonlinearities are taken into account, evidence can be obtained of mean reversion to a long-run relationship between the real exchange rate and key fundamentals as implied by the negative and significant coefficient on the adjustment term ecmt−1
The focus on linearities and the estimation of a nonlinear autoregressive distributed lag (NARDL) model, which is shown to outperform the linear autoregressive distributed lag (ARDL) model both within sample and out of sample, is an important contribution to the existing literature which has rarely applied this type of framework; the choice of an appropriate econometric method makes the policy implications of the analysis more reliable

Summary

Introduction

The well-known PPP (purchasing power parity) puzzle (Rogoff, 1996) consists in the fact that real exchange rates appear to be more volatile and to exhibit more persistence than implied by most exchange rate determination models. This has generated an extensive literature aiming to understand the reasons for the empirical failure of PPP (see Taylor, 2006 for a thorough review). The full terms of this licence may be seen at http://creativecommons.org/licences/by/4.0/legalcode

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