Do bilateral real exchange rates contain stochastic trends? This paper concentrates on univariate time-series models and uses the Beveridge-Nelson decomposition method to provide evidence that real exchange rates for dollar-deutsche mark, dollar-yen, dollar-pound, and dollar-Swiss franc contain stochastic trends. Using quarterly data for the period 1971 I to 1993 IV, we find that real exchange rates are nonstationary stochastic process which do not revert to a deterministic path. Two implications of this empirical findings is highlighted in this study. First, what is perceived as excessive fluctuations in the real exchange rate may not actually be so since the equilibrium itself shifts over time. Second, the empirical validity of the purchasing power parity theory needs to be examined within the framework of an econometric model that treats the real exchange rate as containing stochastic trends.
Available at: http://works.bepress.com/donald_snyder/138/