Exchange rate regime and real exchange rate behavior

Abstract

This paper examines exchange rate regimes from the viewpoint of the validity of purchasing power parity (PPP). Specifically, we analyze real exchange rate behavior under various classifications of exchange rate arrangement through panel unit root tests, and also investigate the adjustment speed of nominal exchange rate and relative prices separately through an error correction framework. Our findings are as follows: First, as a result of the panel unit root tests on real exchange rate behavior, industrial countries under “free float†reveal REER stability even though the test results show weak support for this speculation, while developing countries under “hard peg†definitely represent the REER stability, and have full support from the tests. Second, error correction analysis tells us that in industrial countries under “free float,†the adjustment of nominal exchange rate was faster than that of relative prices, while in developing countries under “hard peg†the adjustment of relative prices is faster that that of the nominal exchange rate. We speculate that industrial countries under free float may render exchange rate movements sensitive to the inflation gap, and that developing countries under “hard peg†may produce nonlinear price adjustments toward the REER long-run equilibrium through an anchor-effect of peg on price stabilization.real (effective) exchange rate, exchange rate arrangement, panel unit root tests, error correction analysis, nonlinear price adjustment