Nonlinearities in exchange rate: evidence from smooth transition regression model

Abstract The purchasing power parity puzzle, exchange rate disconnection to macroeconomic fundamentals and pricing to market are central issues of international macroeconomics. Recent research has suggested that these issues can be presented by nonlinear behaviour. In this dissertation, we examine and explain the nonlinearities in the form of regime switching behaviour in real exchange rate series, exchange rate and macroeconomic fundamentals relation and exchange rate pass-through into consumer and import prices. Overall, we find evidence that nonlinearities are important in analysing empirical exchange rate models. The dissertation consists of four self-contained empirical studies. In chapter 2 we examine whether the Markov switching models and exponential smooth transition autoregressive models can give any additional insights into real exchange rate behaviour for several OECD countries. The results show that there are long swings in the real exchange rate series, which can be characterize as a depreciation and an appreciation regime. These regimes are very persistent, although the processes are eventually mean reverting. We estimate a multivariate smooth transition autoregressive model for the euro/dollar exchange rate in chapter 3. The significant point of our analysis is the possibility that a nonlinear specification for the exchange rate series might reveal aspects of the exchange rate dynamics that cannot be picked up by linear models. We find that the euro/dollar exchange rate may display random walk or near random walk behaviour within a certain range but the ability of the exchange rate to wander without any bound is limited by long-term government bond interest rate differentials. In chapter 4 we examine nonlinear relationships between macroeconomic fundamentals and exchange rate for G-7 countries. We estimate a smooth transition error correction model that allows for parameter variation in the error correction form and interest rate differentials. The nonlinearity is determined by the inflation rate differentials between countries. We find significant error correction terms in monetary models. Our findings suggest the importance of nonlinear dynamics for examining deviations from the long-run equilibrium. We examine whether the degree of exchange rate pass-through is dependent on importing country inflation rate in chapter 5. Our model shows that import prices respond differently to exchange rate changes when we are in a high inflation regime compared to a low inflation regime. We also present empirical evidence by estimating pass-through elasticises for several OECD countries. We find that consumer prices are not very sensitive to exchange rate changes. For aggregate import prices, we find partial or full exchange rate pass-throughs. The tested nonlinear regime specific models proved appropriate for testing exchange rate dynamics for several currency pairs. Furthermore, we were able to present that macroeconomic fundamentals are important predictors of exchange rates