Economics Letters 66 2000 127–136
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Real exchange rate behavior in the Middle East: a re-examination
Lucio Sarno
University College , University of Oxford, Oxford OX1 4BH, UK
Received 9 September 1998; accepted 26 July 1999
Abstract
This letter extends recent work by Bahmani-Oskooee Bahmani-Oskooee, M., Do exchange rates follow a random walk process in Middle Eastern countries? Economics Letters 1998;58:339–344 on testing long-run
purchasing power parity for Middle Eastern countries during the post-Bretton Woods period. Using multivariate nonlinear models, strong support is provided for highly nonlinear reversion of real exchange rates toward a
stable equilibrium for each country examined.
2000 Elsevier Science S.A. All rights reserved.
Keywords : Purchasing power parity; Real exchange rate; Middle East; Nonlinearity
JEL classification : C22; F31
1. Introduction
This letter re-examines the validity of the long-run purchasing power parity PPP hypothesis using data for 11 Middle Eastern countries during the post-Bretton Woods period, extending the recent study
by Bahmani-Oskooee 1998. Bahmani-Oskooee tested long-run PPP using quarterly data for a set of 11 Middle Eastern countries over the period 1971–1994, providing mixed results on the basis of
conventional univariate tests for nonstationarity applied to real exchange rates.
PPP may be tested by executing nonstationarity tests on real exchange rates since the logarithm of the real bilateral exchange rate, q may be defined as the deviation from PPP according to the identity:
t
q ; s 1 p 2 p , where s is the logarithm of the nominal exchange rate domestic price of foreign
t t
t t
t
currency at time t, and p and p are the logarithms of the domestic and foreign price levels,
t t
Tel.: 144-186-527-1952; fax: 144-186-527-1094. E-mail address
: lucio.sarnoeconomics.ox.ac.uk L. Sarno 0165-1765 00 – see front matter
2000 Elsevier Science S.A. All rights reserved.
P I I : S 0 1 6 5 - 1 7 6 5 9 9 0 0 1 9 2 - 5
128 L
. Sarno Economics Letters 66 2000 127 –136
respectively. While the real exchange rate may be subject to short-run variation, a necessary condition for PPP to hold in the long run is that the real exchange rate be covariance stationary, not driven by
permanent shocks since nonstationarity of a real exchange rate implies theoretically infinite divergence of purchasing power across the countries considered, expressed in the same currency.
The enormous relevant empirical literature provides mixed results on the validity of long-run PPP for full surveys see Froot and Rogoff, 1995; Rogoff, 1996; for a brief excursus, see the introduction
in Taylor and Sarno, 1998. Nevertheless, an interesting emerging line of research stresses the importance of allowing for nonlinearity in the adjustment of the real exchange rate toward its long-run
equilibrium, illustrating how linear nonstationarity tests may not detect mean reversion if the true data generating process DGP of the real exchange rate is a stationary nonlinear process e.g. inter alios,
Michael et al., 1997. Also, the fact that PPP appears to hold more closely when there are large variations in relative prices e.g. Frenkel, 1976; Taylor and McMahon, 1988 suggests that the speed
of adjustment toward long-run PPP may vary more than proportionately with the size of the shock to the real exchange rate, and the degree of mean reversion in the real exchange rate may vary
nonlinearly with the level of the real exchange rate; this fact is particularly relevant in the present context, given the high inflation rates experienced by some of the countries examined, especially in
the 1980s. Theoretically, moreover, nonlinear, smooth, symmetric real exchange rate adjustment to a stable equilibrium level is predicted by a number of recent contributions on real exchange rate
determination in presence of transactions costs or transport costs, mainly following Dumas 1992.
In this letter, using nonlinear econometric modeling techniques, strong evidence is provided suggesting that deviations from PPP revert to a constant equilibrium level in a nonlinear fashion
during the recent float for each of the Middle Eastern countries considered, also offering a potential explanation to the mixed results of Bahmani-Oskooee 1998. The estimated models display local
instability and global stability, predicting that the real exchange rate is a unit root process in the neighborhood of its long-run equilibrium, whilst adjusting faster with the absolute size of the
deviation from equilibrium. The model proposed may be viewed as a nonlinear error correction model ECM in the form of a smooth transition regression STR which, after imposing a number of
restrictions, becomes the smooth transition autoregressive STAR process used by some early empirical literature using nonlinear models in this context. Testing these restrictions in the STR
reveals, however, that assuming a priori a STAR model for the real exchange rate often leads to misspecification, as the restrictions only hold for a limited number of countries.
2. Nonlinear real exchange rate adjustment
