Transaction Costs and Nonlinear Adjustment of Real Exchange Rates: STAR Model (Case Study of IRAN)

The recent yearsʹ studies on general equilibrium models show that equilibrium models in real exchange rate determination, considering transactions costs, imply a nonlinear adjustment process toward Purchasing Power Parity (PPP). The normal cointegration tests, in which the effects of transactions costs are ignored, often result in failure of PPP theory in the long run. In this research, considering transactions costs and nonlinear PPP adjustment, it is tried to review the adjustment trend of PPP deviations. At first, using two series of monthly and annual data for the period of 1975-2007, the linear adjustment process hypothesis of PPP deviations is tested against Smooth Transition Autoregressive (STAR) adjustment process and accordingly linear adjustment theory is rejected significantly. Then, STAR models are estimated using Newton-Raphson algorithm, and maximization of the conditional maximum likelihood function. Systematic pattern of nonlinear estimation provides strong evidence of mean-reverting behavior for PPP deviation in the long run. Though, in the short run, the PPP follows random walk behavior