The Response of Real Exchange Rates to Various Economic Shocks

Substantial fluctuations in real exchange rates, i.e., deviations from purchasing power parity (PPP), which closely mirror movements in nominal rates, have been one of the most notable international economic events since the breakdown of the Bretton Woods system. Dornbusch's disequilibrium theory [9], which presumes different speeds of adjustment in assets and goods markets, offers an explanation for temporary deviations from PPP only. Models assuming PPP as a long-run relationship have not been successful in interpreting the movements of the real exchange rates. Although, studies conducted for countries experiencing high or hyper-inflation provide evidence favoring PPP [42; 30; 29], the empirical evidence on PPP for industrialized, low inflation countries is not generally favorable.1 This is consistent with the view that PPP may hold better in high-inflation countries where the disturbances to their economies are mostly monetary in origin [31, 123-24], but PPP may not hold well when the real disturbances, which change equilibrium relative prices, dominate. Statistical evidence indicates that the real exchange rates of many countries are likely to be nonstationary or have long memory. That is, changes in the real values of many currencies tend to persist for very long period of time. This persistence implies that fluctuations in the real exchange rates are largely due to long-lasting effect of real disturbances. After revealing that "PPP does not hold as a long-run concept" for several exchange rates, Flynn and Boucher [12, 121] suggest that "One possible explanation ... is that there are time-varying real factors that are omitted from the PPP relationship." There are several well-established reasons why the real exchange rates may change in response to real disturbances. In the first place, permanent exogenous shocks to the tradable sector of the economy call for changes in competitiveness. For instance, a rise in the real price of oil will worsen the balance of trade position of a net oil-importing country and, therefore, call for a real depreciation of the currency of the country in order to improve its competitive position [32]. Second, when countries are growing at different rates, "productivity bias" will typically result in

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