TY - JOUR

T1 - Bayesian analysis of nonlinear exchange rate dynamics and the purchasing power parity persistence puzzle

AU - Lo, Ming

AU - Morley, James

PY - 2015/3

Y1 - 2015/3

N2 - We investigate the persistence of real exchange rates using Bayesian methods. First, an algorithm for Bayesian estimation of nonlinear threshold models is developed. Unlike standard grid-based estimation, the Bayesian approach fully captures joint parameter uncertainty and uncertainty about complicated functions of the parameters, such as the half-life measure of persistence based on generalized impulse response functions. Second, model comparison is conducted via marginal likelihoods, which reflect the relative abilities of models to predict the data given prior beliefs about model parameters. This comparison is conducted for a range of linear and nonlinear models and provides a direct evaluation of the importance of nonlinear dynamics in modeling exchange rates. The marginal likelihoods also imply weights for a model-averaged measure of persistence. The empirical results for real exchange rate data from the G7 countries suggest general support for nonlinearity, with the strength of the evidence depending on which country pair is being considered. However, the model-averaged estimates of half-lives are almost always as small or smaller than for the linear models alone, suggesting that the purchasing power parity persistence puzzle is less of a puzzle than previously thought

AB - We investigate the persistence of real exchange rates using Bayesian methods. First, an algorithm for Bayesian estimation of nonlinear threshold models is developed. Unlike standard grid-based estimation, the Bayesian approach fully captures joint parameter uncertainty and uncertainty about complicated functions of the parameters, such as the half-life measure of persistence based on generalized impulse response functions. Second, model comparison is conducted via marginal likelihoods, which reflect the relative abilities of models to predict the data given prior beliefs about model parameters. This comparison is conducted for a range of linear and nonlinear models and provides a direct evaluation of the importance of nonlinear dynamics in modeling exchange rates. The marginal likelihoods also imply weights for a model-averaged measure of persistence. The empirical results for real exchange rate data from the G7 countries suggest general support for nonlinearity, with the strength of the evidence depending on which country pair is being considered. However, the model-averaged estimates of half-lives are almost always as small or smaller than for the linear models alone, suggesting that the purchasing power parity persistence puzzle is less of a puzzle than previously thought

KW - Bayesian analysis

KW - Real exchange rate dynamics

KW - Purchasing power parity

KW - Nonlinear threshold models

KW - Bayesian model averaging

KW - Half lives

U2 - 10.1016/j.jimonfin.2014.12.003

DO - 10.1016/j.jimonfin.2014.12.003

M3 - Journal article

VL - 51

SP - 285

EP - 302

JO - Journal of International Money and Finance

JF - Journal of International Money and Finance

SN - 0261-5606

ER -