Nonlinearities and asymmetric adjustment to PPP in an exchange rate model with inflation expectations

CESifo Working Paper No. 8921. This version is free to view and download for private research and study only at https://www.cesifo.org/en/publikationen/2021/working-paper/nonlinearities-and-asymmetric-adjustment-ppp-exchange-rate-model. Not for re-distribution or re-use. © copyright holder. This article will be published in a revised form in Journal of Economic Studies https://doi.org/10.1108/JES-02-2021-0109.Copyright © 2021, Christina Anderl and Guglielmo Maria Caporale. Purpose: This paper aims to explain real exchange rate fluctuations by means of a model including both standard fundamentals and two alternative measures of inflation expectations for five inflation targeting countries (UK, Canada, Australia, New Zealand, Sweden) over the period January 1993-July 2019. Design/Methodology/Approach: Both a benchmark linear ARDL model and a nonlinear ARDL (NARDL) specification are considered. Findings: The results suggest that the nonlinear framework is more appropriate to capture the behaviour of real exchange rates given the presence of asymmetries both in the long and short run. In particular, the speed of adjustment towards the PPP-implied long-run equilibrium is three times faster in a nonlinear framework, which provides much stronger evidence in support of PPP. Moreover, inflation expectations play an important role, with survey-based ones having a more sizable effect than market-based ones. Originality: The focus on linearities and the estimation of a NARDL model, which is shown to outperform the linear ARDL model both within sample and out of sample, is an important contribution to the existing literature which has rarely applied this type of framework; the choice of an appropriate econometric method also makes the policy implications of the analysis more reliable; in particular, monetary authorities should aim to achieve a high degree of credibility to manage them and thus currency fluctuations effectively; the inflation targeting framework might be especially appropriate for this purpose