On the relationship between Nominal Exchange Rates and domestic and foreign prices

Abstract

A number of authors have found significant cointegrating relationships between spot exchange rates and domestic and foreign price levels for the major currencies where the magnitude of the coefficients makes economic interpretation of PPP cumbersome. Using theoretically well motivated nonlinear models for "artifitially" created real exchange rates, this paper investigates the properties of two alternative cointegration procedures, namely the Johansen and Saikkonen methodologies. The latter procedure appears to outperform the former one in terms of finding the "true" cointegrating coefficients. The new weights obtained with the Saikkonen method are then used to estimate nonlinear ESTAR model for the real exchange rate. The "new" real exchange rates exhibit, in most cases, much lower half-life shocks than the ones predicted by the Rogoff (1996) puzzle.