Purchasing power parity and the long memory properties of real exchange rates: Does one size fit all?

This paper examines the time series behavior of monthly bilateral real exchange rates (RER) on a comprehensive sample of 78 industrialized and developing countries, using the US Dollar, the UK Pound and the German Deutsche Mark as numeraires. We suggest a three step testing procedure based on recently introduced econometric techniques, in order to assess the mean-reverting properties of the RER and to address the question of whether real exchange rates follow a non linear process or a long memory process.The main results are as follows. Firstly, most of the bilateral real exchange rates under study are not mean-reverting. Secondly, the nonlinear ESTAR type adjustment is far from being prominent. Finally, only few bilateral RER exhibit true long memory mean-reverting properties.

Research Highlights► This article uses a broader set of countries than the set considered in the literature: it thus considers monthly data on 78 CPI-based bilateral real exchange rates of industrialized and developing economies, over the period 1970-2006. ► For each currency, it considers three bilateral nominal exchange rates, the numeraire being alternatively US Dollar, UK Pound and German Mark. ► It uses recent econometric techniques to detect long-memory process or short-memory process with structural breaks. ► The sequential testing strategy consists of three steps, then we compute impulse-response functions in order to evaluate half-lives for the true long memory mean-reverting bilateral RER. ► The main results are as follows. Firstly, most of the bilateral RER appear to be non mean-reverting processes. Secondly, the nonlinear Exponential Smooth Transition Auto-Regressive (ESTAR) type adjustment is far from being prominent. Finally, only few bilateral RER exhibit true long memory mean-reverting properties. For these true long-memory processes, the half-lives are found to lie between 1 month and 6 years.