P. Michael et al., TRANSACTIONS COSTS AND NONLINEAR ADJUSTMENT IN REAL EXCHANGE-RATES - AN EMPIRICAL-INVESTIGATION, Journal of political economy, 105(4), 1997, pp. 862-879
Equilibrium models of real exchange rate determination in the presence
of transactions costs imply a nonlinear adjustment process toward pur
chasing power parity (PPP). Conventional cointegration tests, which ig
nore the effect of transactions costs, may be biased against the long-
run PPP hypothesis. Our results, using both monthly data for the inter
war period and annual data spanning two centuries, clearly reject the
linear framework in favor of an exponential smooth transition autoregr
essive process. The systematic pattern in the estimates of the nonline
ar models provides strong evidence of mean-reverting behavior for PPP
deviations and helps explain the mixed results of previous studies.