Modeling non-linearities in real effective exchange rates

Abstract The aim of this paper is to test for and model non-linearities in the real effective exchange rates of 10 major industrial countries (the G-10). To exploit non-linear dependencies in exchange rates, we apply the STAR (Smooth Transition Autoregressive) family of models. These non-linear models imply the existence of two distinct regimes in exchange rates, with potentially different dynamic properties, but the transition between the regimes is smooth. Tests reject linearity for eight exchange rates. The real exchange rate process is cyclical in both regimes for almost all countries, and there appears to be some evidence of asymmetry. STAR models outperform Hamilton's Markov regime-switching model in an out-of-sample forecasting contest.

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