On the Relationship Between Exchange Rate Changes and Domestic Production: Asymmetric Cointegration Approach

Abstract

In the international economic literature studies mainly focused on the response of output to exchange rate in developing countries and find a positive, negative and sometimes neutral relationship between exchange rate changes and output in short run and long run. Perhaps, the mixed results are due to assuming a linear dynamic adjustment process in all previous models. This study investigates the asymmetry effects of exchange rate changes on output in a nonlinear modeling framework based on bounds testing approach which provides a flexible model to estimate short and long run effects jointly regardless of the degree of integration of variables. Nonlinearity is introduced by decomposing the real exchange rate into negative and positive partial sums. Using quarterly data for nine countries in a multivariate model, the results show that in the majority of the countries exchange rate changes have an asymmetric effect on domestic production. Following the same path for a bivariate model and using annual data for 68 developed and developing countries, findings still confirm the existence of asymmetry relationship in 24 countries in favor of the nonlinear model. Moreover, the findings are country-specific and cannot be generalized.