Purchasing Power Parity: Evidence from a New Testing Procedure in the Nonlinear Modified ESTAR Framework

The presence of transaction costs in trading implies a non-linear adjustment process of real exchange rates towards Purchasing Power Parity (PPP). This may make the traditional tests for PPP using a linear framework --- ones that generally tend to refute the PPP hypothesis --- unreliable. Instead, this study models the dynamics of the adjustment towards PPP using a modified exponential smooth transition autoregressive process which accounts for both a symmetric and asymmetric adjustment mechanism and tests for the validity of PPP using a new test. Using quarterly data from 10 APEC countries, our results suggest that the bilateral US real exchange rates are mean reverting. Our study provides strong evidence supporting the PPP hypothesis and resolves the inconclusiveness from previous empirical results.