Do the Exchange Rates of the Countries of Freely Floating Exchange Rate Regimes Mean Reverting?

Abstract

The aim of this study is to estimate whether the exchange rates are mean reverting or not in the twenty-three countries, where the free-floating exchange rate system is followed. The study used annual data set over the period of 1961 to 2014. In this study, we have incorporated both first generation panel unit root tests, i.e., the LLC test, the IPS test and the ADF-Fisher test, as well as second-generation panel unit root test, for instance, the Pesaran CIPS test. Some ambiguous results have been appeared in the first-generation tests. However, the second-generation test has failed to resolve the ambiguity. Hence, one cannot firmly assert from the results of this study that the PPP theory is valid in the freely floating exchange regime countries. Since, the exchange rates do not mean reverting, demand-side factors cause shocks in the market rather than the supply-side. Furthermore, relative change of the price levels of two trading partners is not properly reflected in the relative change of the nominal exchange rate movements. Consequently, the relative PPP theory would not be a complete theory for determining the exchange rates in the long-run for the countries belong to the floating exchange rate regimes.

Keywords: Freely floating exchange rate regime; Panel unit root test