A prominent empirical regularity is the incomplete pass-through of exchange rate changes to domestic price changes, which reflects the failure of the purchasing power parity doctrine. We argue that such disconnection can be explained by the non-linear mean reversion dynamics of exchange rates: As a consequence of various trade barriers, there is a sizeable bu˙er region, a “band of inaction”, within which exchange rates can move independently of prices, thus generating large and persistent deviations from parity. When examining panels of large numbers of disaggregated and tradable agricultural products with a non-linear exchange rate specification, we observe relatively fast adjustment speeds whenever deviations are sufficiently large so as to induce arbitrage. On the other hand, when deviations fall within the band of inaction, there is evidence that movements in rates follow a random walk. Additionally, the speed of adjustment is asymmetric, in the sense that positive deviations are adjusted faster than negative deviations.
|Name||Economics Discussion Papers|