Nonlinearities and asymmetric adjustment to PPP in an exchange rate model with inflation expectations

Journal article


Anderl, C. and Caporale, G. (2021). Nonlinearities and asymmetric adjustment to PPP in an exchange rate model with inflation expectations. Journal of Economic Studies. https://doi.org/10.1108/JES-02-2021-0109
AuthorsAnderl, C. and Caporale, G.
Abstract

Purpose
This paper aims to explain real exchange rate fluctuations by means of a model including both standard fundamentals and two alternative measures of inflation expectations for five inflation targeting countries (the UK, Canada, Australia, New Zealand and Sweden) over the period January 1993–July 2019.

Design/methodology/approach
Both a benchmark linear autoregressive distributed lag (ARDL) model and a nonlinear autoregressive distributed lag (NARDL) specification are considered.

Findings
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 purchasing power parity (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.

Originality/value
The focus on linearities and the estimation of a NARDL model, which is shown to outperform the linear ARDL model both within sample and out of sample, is an important contribution to the existing literature which has rarely applied this type of framework; the choice of an appropriate econometric method also makes the policy implications of the analysis more reliable; in particular, 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.

KeywordsNonlinearities; Asymmetric adjustment; PPP; Real Exchange Rate; Inflation Expectations
Year2021
JournalJournal of Economic Studies
PublisherEmerald
Digital Object Identifier (DOI)https://doi.org/10.1108/JES-02-2021-0109
Web address (URL)https://www.emerald.com/insight/content/doi/10.1108/JES-02-2021-0109/full/html
Publication dates
Print10 Aug 2021
Publication process dates
Accepted23 Jun 2021
Deposited30 Sep 2021
Publisher's version
License
File Access Level
Open
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10-1108_JES-02-2021-0109.pdf
License: CC BY 4.0
File access level: Open

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