Thresholds Unit Roots Test and Out-of-sample Forecasting of Real Effective Exchange Rates

In this paper, we apply standard ADF and KPSS tests as well as the new threshold test, which allows non-linearity in the testing procedure, to the real effective exchange rate of 27 industrial countries. The main conclusions are in order. First, we find strong evidence for nonlinearity. Second, the one-sided Wald test provides support for PPP in more countries than standard tests, which is consistent with the findings of previous studies. Further, from individual t-ratio tests we find evidence for a two-regime threshold model in which real effective exchange rates are characterized by unit root behavior within a band of real appreciation or depreciation of about 10% and then outside this band, real effective exchange rates are mean reverting. Third, point forecasts generated by the threshold model are superior to those generated by a simple AR in terms of RMSE criteria.