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Real Exchange Rates and Time-Varying Trade Costs

Pavlidis, Efthymios and Paya, Ivan and Peel, David (2011) Real Exchange Rates and Time-Varying Trade Costs. Journal of International Money and Finance, 30 (6). pp. 1157-1179. ISSN 0261-5606

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    Abstract

    This paper re-examines the empirical modeling of Purchasing Power Parity (PPP) deviations in the presence of commodity market frictions. First, we show that a specific type of smooth transition models can closely approximate the functional form of the theoretical adjustment mechanism derived by Dumas (1992) [Dynamic Equilibrium and the Real Exchange Rate in a Spatially Separated World, Review of Financial Studies,5:2153–180] for the case of constant as well as changing trade costs. Second, we develop, for the first time, an empirical model of the real exchange rate which allows for changes in the degree of market integration. By employing a long span of data on the Dollar-Sterling real exchange rate and a micro-founded proxy for trade frictions, we provide novel evidence of a significant relationship between the persistence of the real exchange rate and the level of trade costs. This finding suggests that both the difficulty of detecting PPP and the extend of Rogoff’s puzzle vary over time with the degree of trade restrictiveness. Finally, we highlight policy repercussions of our results.

    Item Type: Article
    Journal or Publication Title: Journal of International Money and Finance
    Subjects:
    Departments: Lancaster University Management School > Economics
    ID Code: 53224
    Deposited By: ep_importer_pure
    Deposited On: 12 Mar 2012 10:02
    Refereed?: Yes
    Published?: Published
    Last Modified: 09 Apr 2014 23:14
    Identification Number:
    URI: http://eprints.lancs.ac.uk/id/eprint/53224

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