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Smooth transition models and arbitrage consistency

Research output: Working paper

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Abstract

Slow adjustment of real exchange rate towards its long run equilibrium in linear models has long puzzled researchers and provided the impetus for the adoption of particular classes of nonlinear models. The exponential smooth transition model has been particularly successful as an ex post characterization of time series purchasing power parity data providing faster adjustment speeds. In this paper we discuss some of its theoretical limitations as an ex ante data generating mechanism since one interpretation of it is that expectations are adaptive. We propose a new nonlinear model which is conceptually superior to the ESTAR model since it is consistent with rational expectations. One of the advantages of the model is that it can be solved and estimated by nonlinear least squares. Using monthly post-1973 real exchange rate data, we show that the model implies even faster speeds of adjustment.