Real exchange rates and hysteresis: does nominal exchange rate volatility matter?

Abstract

Many of the empirical studies on purchasing power parity (PPP) have relied on unit root tests of the real exchange rate. With stationarity of the real exchange rate as a necessary condition for PPP, failure to reject the unit root null is taken as evidence against the PPP hypothesis. Finding a unit root in real exchange rates is consistent with a class of theoretical models with nominal price rigidities such as menu costs. These models suggest that a hysteresis effect should be found in real exchange rates. The failure to reject the unit root null is often interpreted as evidence of hysteresis. This study asks whether nominal exchange rate volatility is a contributing factor for the observed hysteresis effect. Using data from EU countries we do not find nominal exchange rate volatility as a significant determinant of hysteresis in real exchange rates.