Testing for threshold regulation in presence of measurement error with an application to the PPP hypothesis

Abstract: Regulation is an important feature characterising many dynamical phenomena and can be tested within the threshold autoregressive setting, with the null hypothesis being a global non-stationary process. Nonetheless, this setting is debatable since data are often corrupted by measurement errors. Thus, it is more appropriate to consider a threshold autoregressive moving-average model as the general hypothesis. We implement this new setting with the integrated moving-average model of order one as the null hypothesis. We derive a Lagrange multiplier test which has an asymptotically similar null distribution and provide the first rigorous proof of tightness pertaining to testing for threshold nonlinearity against difference stationarity, which is of independent interest. Simulation studies show that the proposed approach enjoys less bias and higher power in detecting threshold regulation than existing tests when there are measurement errors. We apply the new approach to the daily real exchange rates of Eurozone countries. It lends support to the purchasing power parity hypothesis, via a nonlinear mean-reversion mechanism triggered upon crossing a threshold located in the extreme upper tail. Furthermore, we analyse the Eurozone series and propose a threshold autoregressive moving-average specification, which sheds new light on the purchasing power parity debate.