Nonlinear Adjustment, Purchasing Power Parity and the Role of Nominal Exchange Rates and Prices

Although the literature on purchasing power parity (PPP) is rich in controversy, the relative contribution of prices and nominal exchange rates to real exchange rate movements which restore PPP disequilibria has rarely been put under any close scrutiny. Using monthly data from 1973:01 to 2009:12 from the USA, UK, Germany, France and Japan, this paper as a first step applies a co-integrated VAR framework to test for stationary real exchange rates and linear adjustments in prices and nominal exchange rates. As a second step, ESTR error correction models are fitted to test whether nonlinear error correctional behavior characterizes the data. The results clearly indicate that the nominal exchange rate is responsible for the nonlinear mean reverting behavior in real exchange rates and also mainly drives overall adjustment. Applying dynamic stochastic simulations based on the estimated models, this study also confirms recent results that the half-life times of real exchange rate shocks are significantly smaller than the consensus benchmark of three to five years