A Non-Linear Multivariate Model of the U.K. Real Exchange Rate

This paper discusses linearity testing for the UK real exchange rate within a multivariateframework. First we estimate a long-run real exchange rate relationship within a system involvingreal wages, the unemployment rate and the real price of oil. Then we adopt a logistic transitionfunction for the estimated relationship and show that non-linearities in the discrepancy betweenthe real exchange rate and its implied long-run level affect the short-run real exchange rateequation. We also find that when the real exchange rate is undervalued, unemployment falls asfirms respond to an improvement in domestic competitiveness by increasing their demand forlabour. At the same time, workers respond to the improvement in domestic competitiveness bydemanding and getting higher wages. Further, the effect on unemployment and wages is nonlinear.