Pavlidis, E and Paya, I and Peel, D (2009) Real Exchange Rates and Time-Varying Trade Costs. Working Paper. The Department of Economics, Lancaster University.
Previous empirical work on the Purchasing Power Parity does not explicitly account for time-varying trade costs. Motivated by the recent gravity literature we incorporate a microfounded measure of trade costs into two nonlinear regression models for the real exchange rate. Using data for the dollar-sterling real exchange rate from 1830 to 2005, we provide significant evidence in favor of a positive relation between the level of trade costs and the degree of persistence of the real exchange rate.
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