Explaining the persistence of deviations from PPP: a non-linear Harrod-Balassa-Samuelson effect?

Abstract

Researchers have long been vexed by the persistence of real exchange rate deviations from linear-form PPP. Two of the more popular explanations involve the role of supply shocks to the exchange rate, for instance as captured by the Harrod-Balassa-Samuelson (HBS) hypothesis that emphasizes the role of intra-economy productivity differentials, and non-linear adjustment dynamics reflecting, inter alia, non-trivial transaction costs and investor heterogeneity within the foreign exchange market. hese explanations are typically considered in isolation of one another. By contrast, this study explores whether a non-linear model that incorporates the HBS effect, as well as Terms of Trade shocks, can account for the persistence of deviations from PPP. Using quarterly data for three major exchange rates, it concludes in favour of a significant explanatory role for both variables within linear VECMs and non-linear ESTAR models. However, no strong evidence is found to suggest that these ESTAR models encompass their linear alternatives, implying that the economic benefit of modelling PPP deviations as a non-linear process is limited once account has been made of relevant supply shocks.

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