Mean Reversion in Real Exchange Rates in Seventy LDCs: An Empirical Investigation

Abstract

So far, comprehensive investigations of the behavior of real exchange rates in LDCs are scarce in the literature. As several LDCs policymakers have been implementing a purchasing power parity (PPP)-oriented exchange rate policy while others have continually intervened in the foreign exchange rate market, there is need to ascertain whether or not there is empirical support for mean reversion of real exchange rates or long-run PPP in LDCs. This study investigates the long-run PPP hypothesis in seventy LDCs. Our data are real effective exchange rates (REER) for the period 1980:1 through 2009:10 (i.e., 358 observations). Our results reveal evidence of mean reversion that is significantly stronger compared to that obtained by using linear tests alone, strengthening the support for PPP. The results find strong evidence in favor of both linear and nonlinear mean reversions, with the nonlinear mean reversion dominating beyond the 2005 sample period.