Mean-Reversion versus PPP Adjustment: The Two Regimes of Exchange Rate Dynamics Under the EMS, 1979-1998

Marie Bessec ()

No 1305, Econometric Society World Congress 2000 Contributed Papers from Econometric Society

Abstract: This paper examines jointly the empirical relevance of the mean-reversion and the Purchasing Power Parity (PPP) hypotheses in the exchange rate dynamics within the European Exchange Rate Mechanism (ERM). Given the non stationarity and the nonlinearities characterizing foreign exchange rate dynamics, we analyse this question in the framework of a Markov-Switching Error Correction model : it allows a discontinuous adjustment towards the cointegration relationship. We find that the European exchange rates of the ERM members display a strong mean-reversion in the credible regime, whereas they adjust to the PPP during the volatile period.The first effect is due to the stabilizing effect of a credible target-zone, while the second one can be explained by the realignments made in accordance with the underlying inflation rates in order to maintain the competitiveness between the ERM members.

Date: 2000-08-01
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