Nonlinear Analysis in Economic & Financial

Abstract

Traditional economic and financial models often use linear frameworks to analyze the relationships between prices and fundamentals. For instance, the cost of carry model suggests that stock futures prices should align with spot prices (Taylor et al., 2000), while log-linear present value models propose a linear relationship between log dividends and stock prices (Campbell and Shiller, 1988). Similarly, housing market models predict stability in the house price-to-income ratio if residential property values are consistently proportional to future real disposable income (Black et al., 2006). However, empirical research using linear unit root tests frequently shows that deviations from fundamental values do not revert to equilibrium as theory suggests. This empirical discrepancy indicates that linear models and tests might be inadequate in capturing real-world dynamics. Recent studies propose that nonlinear dynamics might be a key factor in this misalignment, suggesting that linear unit root tests could yield misleading results when nonlinear mechanisms are at play in macroeconomic and asset markets.