Exchange rate parities and Taylor rule deviations

Abstract

Copyright © The Author(s) 2022. This paper investigates the PPP and UIP conditions by taking into account possible nonlinearities as well as the role of Taylor rule deviations under alternative monetary policy frameworks. The analysis is conducted using monthly data from January 1993 to December 2020 for five inflation-targeting countries (the UK, Canada, Australia, New Zealand and Sweden) and three non-targeting ones (the USA, the Euro Area and Switzerland). Both a benchmark linear VECM and a nonlinear Threshold VECM are estimated; the latter includes Taylor rule deviations as the threshold variable. The results can be summarized as follows. First, the nonlinear specification provides much stronger evidence for the PPP and UIP conditions, the estimated adjustment speed towards equilibrium being twice as fast. Second, Taylor rule deviations play an important role: the adjustment speed is twice as fast when deviations are small and the credibility of the central bank is higher. Third, inflation targeting tends to generate a higher degree of credibility for the monetary authorities, thereby reducing deviations of the exchange rate from the PPP- and UIP-implied equilibrium.