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A NONLINEAR ANALYSIS OF THE REAL EXCHANGE RATE–CONSUMPTION RELATIONSHIP

Published online by Cambridge University Press:  11 July 2017

Efthymios G. Pavlidis,
Ivan Paya and
David A. Peel
Efthymios G. Pavlidis
Affiliation:
Lancaster University Management School
Ivan Paya*
Affiliation:
Lancaster University Management School
David A. Peel
Affiliation:
Lancaster University Management School
*
Address correspondence to: Ivan Paya, Department of Economics, Lancaster University Management School, Lancaster LA1 4YX, UK; e-mail: i.paya@lancaster.ac.uk.
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Abstract

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A variety of international macroeconomic models predict a relationship between the real exchange rate and consumption. The empirical evidence in favor of such a relationship is limited, the so-called Backus and Smith puzzle. In this paper, we extend the analysis to allow for nonlinear dynamics and volatility changes across exchange rate regimes. Our findings suggest that long-run relationships in line with standard international business cycle models do exist for many Organization for Economic Co-operation and Development (OECD) countries. Further, Monte Carlo experiments illustrate that the nonlinear models can generate the Backus and Smith and the exchange rate disconnect puzzles. In this paper, we also contribute to the nonlinear real exchange rate literature by establishing a theoretical relationship between volatility and persistence. In accordance with the theoretical results, our empirical findings suggest that the increase in volatility in the post-Bretton Woods era is associated with relatively fast mean reversion of the real rate toward its equilibrium value.

Keywords

Exponential Smooth Transition Regression ModelVolatility ShiftsConditional HeteroskedasticityImpulse Response Analysis

Information

Type
Articles
Information
Macroeconomic Dynamics , Volume 22 , Special Issue 7: Recent Insights into Financial, Housing, and Monetary Markets , October 2018, pp. 1825 - 1843
Copyright
Copyright © Cambridge University Press 2017 

Footnotes

We are grateful to participants of the 2nd International Workshop on Financial Markets and Nonlinear Dynamics for useful comments and suggestions. Documentation about the data used in this paper is available from the Lancaster University data archive at http://dx.doi.org/10.17635/lancaster/researchdata/84.

References

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