A re-examination of purchasing power parity in Japan and Taiwan

Equilibrium models of real exchange rate determination, in the presence of transaction costs, imply a nonlinear adjustment process toward purchasing power parity (PPP). In this paper, we re-examine the hyothesis of PPP allowing for the adjustment to follow a nonlinear process. For the country pairs of U.S. Japan and U.S.-Taiwan during the period of 1974M1-199TM12 and 1960M1-1997M12, respectively, our results clearly reject the linear framework in favor of an exponential smooth transition autoregressive (ESTAR) process for PPP deviations. The results provide an alternative explanation for the failure of long-run PPP in the existing studies.