Real exchange rates and structural breaks

Abstract

Cointegration tests often fail to detect the existence of long-term relationships such as purchasing power parity for two reasons: (i) these tests have low power and (ii) structural shocks can alter the long-run real exchange rate. In this paper, the long-run movements of five exchange rates relative to the US Dollar and five European exchange rates relative to the Deutsche Mark are investigated. In particular, corrected cointegration tests are applied, which take into account the possibility of a structural break at an unknown date. Empirical evidence is found that structural changes can be responsible for most exchange rate deviations from their equilibrium, defined by purchasing power parity or a generic monetary model.