Real exchange rates and economic fundamentals: An investigation based on a Markov-STAR model

In this paper we introduce a new nonlinear Markov-STAR model to capture both the markov switching and smooth transition dynamics for real exchange rates. The Markov switching part captures the effect of time variations of the equilibrium exchange rates, while the smooth transition part models the nonlinear adjustment to the equilibrium. We describe the model and the estimation algorithm. In an empirical application the Markov-STAR model is applied to the real exchange rates of 18 countries. In an effort to make sense of the switching equilibrium rates, we relate relevant macroeconomic variables, such as output gap, inflation rate, and economic uncertainty to the smoothed probabilities through logit regressions. We find that, consistent with economic models, a deteriorating economy relative to US economy tends to significantly increase the likelihood of the real exchange rate to depreciate relative to the US Dollar for the majority of the countries under investigation. Furthermore, a higher economic uncertainty in the US tends to significantly increase the likelihood of a real exchange rate appreciation for many advanced European economies while it is exactly the opposite for some developing countries. Finally, we also find strong evidence that rising economic uncertainty tends to be associated with a higher exchange rate volatility.

[1]  M. Woodford,et al.  INTEREST AND PRICES: FOUNDATIONS OF A THEORY OF MONETARY POLICY , 2005, Macroeconomic Dynamics.

[2]  Chang‐Jin Kim,et al.  Dynamic linear models with Markov-switching , 1994 .

[3]  Timo Teräsvirta,et al.  Smooth transition autoregressive models - A survey of recent developments , 2000 .

[4]  P. Bacchetta,et al.  On the Unstable Relationship between Exchange Rates and Macroeconomic Fundamentals , 2009 .

[5]  C. Engel,et al.  Exchange Rates and Interest Parity , 2013 .

[6]  David E. Rapach,et al.  The out-of-sample forecasting performance of nonlinear models of real exchange rate behavior , 2006 .

[7]  David E. Rapach,et al.  Testing the monetary model of exchange rate determination: new evidence from a century of data , 2002 .

[8]  Alan M. Taylor,et al.  Potential Pitfalls for the Purchasing-Power-Parity Puzzle? Sampling and Specification Biases in Mean-Reversion Tests of the Law of One Price , 2000 .

[9]  Simon M. Potter.  Nonlinear Time Series Modelling: An Introduction , 1999 .

[10]  Philipp Sibbertsen,et al.  The dynamics of real exchange rates - A reconsideration , 2014 .

[11]  James D. Hamilton,et al.  New directions in business cycle research and financial analysis , 2002 .

[12]  Mark P. Taylor,et al.  Nonlinear Mean‐Reversion in Real Exchange Rates: Toward a Solution To the Purchasing Power Parity Puzzles , 2001 .

[13]  Nathan S. Balke,et al.  The contribution of economic fundamentals to movements in exchange rates , 2013 .

[14]  Jun Ma,et al.  Recent Advances in Estimating Nonlinear Models , 2014 .

[15]  C. Engel,et al.  Exchange Rates and Fundamentals , 2003, Journal of Political Economy.

[16]  Hili Ouagnina,et al.  On the estimation of nonlinear time series models , 1995 .

[17]  David H. Papell,et al.  Additional Evidence of Long-Run Purchasing Power Parity with Restricted Structural Change , 2006 .

[18]  M. Pesaran.  Impulse Response Analysis , 2015 .

[19]  James D. Hamilton.  A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle , 1989 .

[20]  T. Teräsvirta.  Specification, Estimation, and Evaluation of Smooth Transition Autoregressive Models , 1994 .

[21]  Mark P. Taylor,et al.  The Economics of Exchange Rates , 2002 .

[22]  Charles Engel,et al.  Taylor Rules and the Deutschmark-Dollar Real Exchange Rate , 2004 .

[23]  E. Fama,et al.  Forward and spot exchange rates , 1984 .

[24]  Eric Zivot,et al.  THRESHOLD COINTEGRATION AND NONLINEAR ADJUSTMENT TO THE LAW OF ONE PRICE , 2001, Macroeconomic Dynamics.

[25]  S. Saxena,et al.  The Monetary Model Strikes Back: Evidence from the World , 2008 .

[26]  M. Hashem Pesaran,et al.  Impulse response analysis in nonlinear multivariate models , 1996 .

[27]  State of the Art Unit Root Tests and Purchasing Power Parity , 2004 .

[28]  Lucio Sarno,et al.  Deviations from purchasing power parity under different exchange rate regimes: Do they revert and, if so, how? , 2006 .

[29]  J. Morley,et al.  Bayesian Analysis of Nonlinear Exchange Rate Dynamics and the Purchasing Power Parity Persistence Puzzle , 2013 .

[30]  Chang‐Jin Kim,et al.  The Long-Run U.S./U.K. Real Exchange Rate , 1996 .

[31]  C. Engel.  Long-Run PPP May Not Hold after All , 1996 .

[32]  David H. Papell,et al.  Quasi purchasing power parity , 1998 .

[33]  D. Peel,et al.  Transactions Costs and Nonlinear Adjustment in Real Exchange Rates; An Empirical Investigation , 1997, Journal of Political Economy.

[34]  G. Lindgren.  Markov regime models for mixed distributions and switching regressions , 1978 .

[35]  Ying-Wong Cheung,et al.  On the purchasing power parity puzzle , 2000 .

[36]  Jesper Hansson,et al.  Real Exchange Rates and Switching Regimes , 2000 .

[37]  James D. Hamilton,et al.  Long Swings in the Dollar: Are They in the Data and Do Markets Know It? The American Economic Review , 1990 .

[38]  Mark P. Taylor,et al.  Why is it so Difficult to Beat the Random Walk Forecast of Exchange Rates? , 2001 .

[39]  Nonlinear PPP Deviations: A Monte Carlo Investigation of Their Unconditional Half-Life , 2006 .

[40]  Paul I. Nelson,et al.  On Conditional Least Squares Estimation for Stochastic Processes , 1978 .

[41]  C. Engel.  Can the Markov Switching Model Forecast Exchange Rates? , 1992 .

[42]  R. MacDonald.  The economics of exchange rates , 1991 .

[43]  C. Engel,et al.  Federal Reserve Bank of Dallas Globalization and Monetary Policy Institute Long-horizon Forecasts of Asset Prices When the Discount Factor Is Close to Unity , 2022 .