Exchange Rate Dynamics Revisited: A Panel Data Test of the Fractional Integration Order

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Abstract

We test the possibility that exchange rates from nine developed countries have a unit root against the alternate possibility that they are fractionally integrated. Theoretically, exchange rates are only expected to follow a random walk under restrictive assumptions. However, most traditional unit root tests cannot reject a unit root in exchange rates, and time series tests that allow for fractional integration have given inconclusive results. To increase the power of the test of the integration order we develop two panel data tests of the fractional integration order. Monte Carlo simulations show that these tests are correctly sized and have relatively high power compared to other similar tests. Moreover, our empirical results show that we can reject a unit root in exchange rates with a high probability, but the integration order is close to one. This indicates that exchange rates are mean-reverting, although the reversion is slow, resulting in long swings.

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Research areas and keywords

Subject classification (UKÄ) – MANDATORY

  • Economics

Keywords

  • Nominal exchange rates, Panel data, Fractional integration, Long memory
Original languageEnglish
Pages (from-to)389-409
JournalEmpirical Economics
Volume47
Issue number2
Publication statusPublished - 2014
Publication categoryResearch
Peer-reviewedYes