Testing PPP hypothesis under considerations of nonlinear and asymmetric adjustments: new international evidence

Abstract

This paper provides new empirical evidence of purchasing power parity (PPP) in 18 countries. We thoroughly test for the non-stationarity and nonlinearity jointly of the real effective exchange rates (REERs) using a variety of transition functions, which allow for asymmetric adjustment of the REERs depending upon the size and sign of deviation from the equilibrium. The empirical results reveal that the REERs possess nonlinearity. The stationarity of the REERs is strongly dependent upon the size of disequilibrium, which is theoretically attributed to the transaction costs. The autoregressive model associated with the exponential smooth transition function dominates the other transition functions in characterizing the size nonlinearity of the REERs. In addition, if the Heaviside indicator variable of the threshold autoregressive model is assumed to be the lagged real effective exchange rate, then the asymmetric adjustment, theoretically suggested by the price stickiness, is indispensable to validating the PPP hypothesis.