The Roles of Nominal Exchange Rate and Relative Price Adjustments in PPP Reversion

Deokwoo Nam

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Monetary Policy and Economic Impact Financial Markets and Investment Strategies Global Financial Crisis and Policies

Abstract

This paper investigates the roles of the nominal exchange rate and relative prices in restoring purchasing power parity (PPP) by estimating their dynamics with a bivariate threshold vector error correction model. Our empirical results suggest a threshold cointegrating relationship between the nominal exchange rate and relative prices. However, these two variables play different roles in restoring PPP. The nominal exchange rate adjusts to restore PPP only outside the threshold band. Within the band, PPP is restored mainly through adjustments in relative prices.

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References

1996Impulse response analysis in nonlinear multivariate models 1996The Purchasing Power Parity Puzzle 2001Nonlinear Mean‐Reversion in Real Exchange Rates: Toward a Solution To the Purchasing Power Parity Puzzles 2002Testing for two-regime threshold cointegration in vector error-correction models 1997Transactions Costs and Nonlinear Adjustment in Real Exchange Rates; An Empirical Investigation 1992Dynamic Equilibrium and the Real Exchange Rate in a Spatially Separated World 1997Nonlinear Aspects of Goods-Market Arbitrage and Adjustment: Heckscher's Commodity Points Revisited 2001Currency traders and exchange rate dynamics: a survey of the US market

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