Nonlinear dynamics in international finance: evaluating real exchange rate behavior across 20 Eastern and Southeastern European economies

Purpose This paper aims to enhance the understanding of international finance by analyzing the nonlinear dynamics of exchange rates through the lens of the purchasing power parity (PPP) hypothesis. The study focuses on 20 Eastern and Southeastern European economies to explore the relationship between exchange rate movements and PPP within the context of international finance. Design/methodology/approach This study begins with a comprehensive critical review of theoretical and empirical literature on exchange rate behavior in international finance. Recognizing the potential nonlinear dynamics of real exchange rates, the analysis employs various linearity tests, including those proposed by Teräsvirta et al. (1993), White (1989), Keenan (1985), Tsay (1986) and Brock et al.’s test (1996). To assess the PPP, the study investigates the stationarity of monthly real effective exchange rates using three categories of unit root tests: linear tests (ADF, PP), a unit root test with structural breaks (Lee and Strazicich, 2003) and a variety of nonlinear tests (Kapetanios et al., 2003; Kruse, 2011; Sollis, 2009; Hu and Chen, 2016). By combining traditional approaches with advanced methodologies, this framework provides a thorough and nuanced evaluation of PPP. Findings The results demonstrate that while nonlinear unit root tests provide stronger support for purchasing power parity in certain cases, the hypothesis does not hold uniformly across all the countries studied. This indicates varying levels of alignment with PPP, highlighting the complex dynamics of exchange rates in international finance. Consequently, the results reveal that many of the economies examined do not experience price convergence or align in terms of international competitiveness with their trade partners. These findings underscore the need for carefully designed and effective policies tailored to the specific economic contexts of each country. Originality/value This paper makes a significant contribution to the field of international finance by applying advanced nonlinear analysis techniques to examine exchange rate dynamics and the validity of PPP. The research provides new insights into the complexities of PPP and its broader implications for international finance. Furthermore, it scrutinizes the traditional theoretical and empirical models that form the basis of mainstream policy implications, raising concerns about their applicability in certain contexts. The paper delivers robust and comprehensive results, enhancing the understanding of PPP, particularly in economies with diverse exchange rate behaviors.