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Nonlinearities and Asymmetric Adjustment to PPP in an Exchange Rate Model with Inflation Expectations

Christina Anderl and Guglielmo Maria Caporale

No 8921, CESifo Working Paper Series from CESifo

Abstract: This paper estimates a model of the real exchange rate including standard fundamentals as well as two alternative measures of inflation expectations for five inflation targeting countries (UK, Canada, Australia, New Zealand, Sweden) over the period January 1993-July 2019. Both a benchmark linear ARDL model and a nonlinear ARDL (NARDL) specification are considered. 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. 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.

Keywords: nonlinearities; asymmetric adjustment; PPP; real exchange rate; inflation expectations (search for similar items in EconPapers)
JEL-codes: C32 F31 G15 (search for similar items in EconPapers)
Date: 2021
New Economics Papers: this item is included in nep-mac, nep-mon and nep-opm
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