Linear and nonlinear dynamics of real exchange rates

This dissertation models linear and nonlinear specifications of the real exchange rate in various sets and subsets of industrialized countries. The first essay argues that transportation costs and aggregation effects in the market lead to the appearance of unit root behavior in the real exchange rate which leads tests based on a linear framework to misjudge the underlying structure of the data. If this is true, then linear models might fail to reject a unit root null when the underlying data process is actually stationary. I examine an exponential smooth transition autoregression (ESTAR) model of real exchange rates for 16 industrialized countries covering more than a century in length and am able to demonstrate evidence in favor of nonlinear mean reversion for 10 countries in the sample.; The second essay examines an ESTAR model by estimating a system of equations on post Bretton-Woods real exchange rates using the dollar as the numeraire currency. Recognizing that data which includes outliers often finds nonlinearity when the underlying process is linear, I construct a counterfactual experiment to test the ESTAR framework. I modify the data by scaling down the 1985 peak of the dollar to match post-1987 peaks. I find that nonlinear mean reversion is robust to this counterfactual experiment. This model is also robust to changing the numeraire and removing the US dollar altogether.; The third essay uses two innovations to model the real exchange rate implied by a two-country open economy. First, I recognize that advances in the monetary policy rule literature advocate including a lagged interest rate in the interest rate rule. Second, I use new evidence on the assumption of uncovered interest rate parity (UIP) which suggests that short run deviations from risk neutrality alters the path agents take to reach the equilibrium in a rational expectations setting. I derive the implied real exchange rate by using a modified Taylor rule and deviations from UIP in the equilibrium condition to compare its characteristics to the actual real exchange rate. I can conclude that this implied series matches the characteristics of the actual series better than previous attempts.