Transaction Costs and Nonlinear Modelling of Real Exchange Rate Deviations from Purchasing Power Parity: Evidence from the MENA Region

Abstract

The empirical findings supporting the theory of the Purchasing Power Parity (PPP) for the developed and developing countries remain a controversial issue as the empirical evidence is still inconclusive. Indeed, the nature of the deviation dynamics from PPP has strongly challenged the PPP theory and deepened the Rogoff puzzle (Journal of Economic literature XXXIV: 647–668, 1996). This paper contributes to empirical research [Baum et al. (Journal of International Money and Finance 20: 379–399, 2001); Taylor et al. (International Economic review 42(4): 1015–1042, 2001), Michael et al. (Journal of Political Economy 105: 862–879, 1997)] by testing the stationarity of the bilateral real exchange rate of the dollar vis-a-vis the currencies of the MENA countries in a nonlinear framework consistent with the presence of transaction costs and tariff and nontariff barriers in international trade. The use of Terasvirta’s procedure shows that the logistic or exponential smooth transition autoregressive models correctly generate 10 out of 13 real exchange rates of the countries under consideration. The estimation of these statistical models shows nonlinear and globally mean-reverting processes of the real exchange rates in several of these countries but a significant persistence of the exchange rate dynamics in few of them. The estimated transition functions consolidate the nonlinearity of the deviations from the PPP proving that the LSTAR and ESTAR processes are appropriate to analyse the adjustment of the real exchange rates to the PPP.