Nonstationarity in real exchange rates using unit root tests with a level shift at unknown time

The empirical literature that tests for purchasing power parity (PPP) by focusing on the stationarity of real exchange rates has so far provided, at best, mixed results. This paper contributes to this discussion by providing new evidence on the stationarity of bilateral real exchange rates, after allowing for regime changes. We test for a unit root in real exchange rates by allowing for a level shift in the DGP. In doing so, we use the unit root tests proposed by Saikkonen and Lutkepohl [Saikkonen, P. and Lutkepohl, H., 2002, Testing for a unit root in a time series with a level shift at unknown time, Econometric Theory 18, 313-348] and Lanne et al. [Lanne, M., Lutkepohl, H., and Saikkonen, P., 2002, Comparison of unit root tests for time series with level shifts, Journal of Time Series Analysis 23, 667-685], which are based on estimating the deterministic term first by a GLS procedure under the unit root null hypothesis and subtracting it from the original series. We subject the series to three level shifts, namely: a shift dummy, an exponential shift and a rational shift. Our results confirm the nonstationarity of real exchange rate series in the presence of structural breaks during the post-Bretton Woods era. Thus, the real exchange rate behavior may not be so different after all but simply perceived to be so because of the use of previously restrictive unit root tests. (C) 2006 Elsevier Inc. All rights reserved.