Real Exchange Rates. Menzie D. Chinn. University of Wisconsin, Madison and National Bureau of Economic Research. February 4, 2006

Transcription

1 Real Exchange Raes Menzie D. Chinn Universiy of Wisconsin, Madison and Naional Bureau of Economic Research February 4, 2006 Acknowledgmens: Enry prepared for New Palgrave Dicionary. Seven Durlauf and Lawrence Blume provided helpful commens. Address for Correspondence: Rober M. La Follee School of Public Affairs, and Deparmen of Economics, Universiy of Wisconsin, 1180 Observaory Drive, Madison, WI Tel/Fax: +1 (608) /

2 1. The Real Exchange Rae(s) The real exchange rae plays a crucial role in models of he open economy. How should he real exchange rae be defined, how does i behave over ime, and wha deermines i a various ime horizons are all quesions ha have been posed over he years. They have aken on heighened imporance in recen years, as he scope of inernaional ransacions has expanded and more and more economic aciviy is eiher direcly or indirecly affeced by economic aciviy in oher counries. The mos common definiion of he real rae is he nominal exchange rae adjused by price levels. q * s - p + p (1) where s is he log exchange rae defined in unis of home currency per uni of foreign, and p and p* are log price levels. If purchasing power pariy (PPP) holds, hen q is always uniy (or a consan, if price indices are used). One should expec PPP o hold in a world where ransporaion and ransacions coss were negligible, consumpion baskes were idenical, and no arbirage profis exised. Absen hese condiions, he real exchange rae will vary. One way of hinking abou he deerminans of movemens in he real exchange rae is o appeal o a decomposiion. Suppose he price index is a geomeric average of raded and nonraded good prices. p = α p N +(1-α ) p T (2) where he lowercase leers denoe logged values. Then subsiuing (2) ino (1) yields: T q ( s - p + p T* N T * N* T* ) + [ α ( p - p ) + α ( p - p )] q q T + [ ω ] (3) (3 ) Equaion (3) indicaes ha he real exchange rae can be expressed as he sum of hree componens: (i) he relaive price of radables q T, (ii) he inercounry relaive price of nonradables in erms of radables in he home counry ω.

3 2. The Deerminans of he Real Exchange Rae If PPP holds only for radable goods, hen only he second erm in equaion (3 ) can be non-zero, and he relaive radables-nonradables price is he deermining facor in he value of he real exchange rae. Anoher possibiliy is ha all goods are radable, bu no perfecly subsiuable; hen he imperfec subsiues model resuls, and q T is equivalen o q. More generally, boh erms on he righ hand side of equaion (3 ) can ake on non-zero values. In eiher of hese cases, here are a large number of variables ha could influence each relaive price. And of course, here is nohing o rule ou boh relaive price channels as being operaive. In popular discussion, all hree definiions of he real exchange rae are used, someimes leading o considerable confusion. Mos models of he real exchange rae can be caegorized according o which specific relaive price serves as he objec of focus. If he relaive price of nonradables is key, hen he resuling models in a small counry conex have been ermed dependen economy (Saler, 1959, and Swan, 1960) or Scandinavian model. In he former case, demand side facors drive shifs in he relaive price of nonradables. In he laer, produciviy levels and he nominal exchange rae deermine he nominal wage rae and hence he price level, and hence he relaive price of nonradables. In his laer conex, he real exchange rae is a funcion of produciviy (Krueger, 1983: 157). Consequenly, he wo ses of models boh focus on he relaive nonradables price, bu differ in heir focus on he source of shifs in his relaive price. Since he home economy is small relaive o he world economy (hence, one is working wih a one-counry model), he radable price is pinned down by he res-of-he-world supply of raded goods. Hence, he real exchange rae in his case is (p N -p T ). The relaive price of radables definiion is mos appropriae when considering he relaive price ha achieves exernal balance in rade in goods and services. This variable is also wha macroeconomic policymakers refer o as price compeiiveness; hence, anyhing ha affecs he markup of price over cos including boh he level of demand, inpu coss, and marke srucure can deermine he real exchange rae. Noice he dichoomy beween he relaive price of radables and he relaive price of nonradables breaks down when counries specialize in he producion of goods. Then he real exchange rae is he same as he erms of rade; purchasing power pariy would occur only if he wo goods were perfec subsiues (see Lucas, 1982; Sockman, 1980).

4 3. Empirical Modeling and Resuls 3.1 Real exchange rae dynamics In one special case, here is no need o model he real exchange rae: If relaive PPP is assumed o hold, hen q is a consan. Empirically, his is clearly no rue in he shor run, bu could be in he long run. Consequenly, remendous effor has been invesed in invesigaing wheher q is rend saionary or no, even hough rend saionariy is no he same as purchasing power pariy holding (he sronger condiion of mean saionariy is required). Numerous sudies have evaluaed he rend saionariy of q direcly by applicaion of uni roo ess, or indirecly, by assessing wheher he componen series of q exhibi common long erm rends. Broadly speaking, he conclusions in his lieraure are mixed. Generally, panel mehods, long ime samples, and he use of producer or wholesale price indices provide more evidence in favor of a rend revering q han do pure ime series mehods, shor samples, and he use of consumer price indices (see Rogoff, 1996; Taylor and Taylor, 2004). These resuls leave open he possibiliy ha economic variables affec he movemen of exchange raes over he shor as well as he long run. 3.2 Modeling real exchange rae movemens as a funcion of economic variables The modeling of he real exchange rae deerminans can be broken up ino wo main caegories. The firs caegory includes models of he nominal exchange rae which, by virue of he assumpion of sicky prices, become models of he real exchange rae. Firs and foremos among hese are sicky price moneary models ha incorporae exchange rae overshooing, such as Dornbusch (1976) and Frankel (1979). In he long run, purchasing power pariy holds, so ha hese models are only shor run models. The second caegory includes models ha focus on he deerminans of he long run real exchange rae. By far dominan in his caegory are hose ha cener on he relaive price of nonradables. These include he specificaions based on he approaches of Balassa (1964) and Samuelson (1964) ha model he relaive price of nonradables as a funcion of secoral produciviy differenials, including Hsieh (1982), Canzoneri, Cumby and Diba (1999), and Chinn (1999, 2000). They also include hose models ha search more broadly and include demand side deerminans of he relaive price, such as DeGregorio and Wolf (1994). Engel (1999) has cas doub upon he relevance of he relaive nonradables price. He demonsraes ha

5 for he G-7 economies, he variabiliy of q T as proxied by he radable componens of he CPI, is comparable o he variabiliy of ω even a horizons of 15 years. More recenly, some version of he porfolio balance model has been resurreced. Lane and Milesi-Ferrei (2002) have forwarded a model wherein he real rae depends upon he ne foreign asses. Early panel evidence in favor of he imporance of his facor is o be found in Gagnon (1996). Some mehodological approaches do no fall nealy ino one or he oher caegory. The analysis by Mark and Choi (1997) is one insance. They compared he usefulness of moneary and real facors in predicing exchange rae changes over long horizons, and found surprisingly ha moneary facors had persisen effecs on he real exchange rae. Using a differen mehodology, namely a Srucural VAR model, Clarida and Gali (1995) find ha moneary and demand side facors dominae in he deerminaion of exchange raes. Also relying upon a srucural (permanen-ransiory) decomposiion involving he real exchange rae and he curren accoun, Lee and Chinn (forhcoming) find ha posiive permanen shocks (inerpreed as produciviy innovaions) end o appreciae he currency and (a leas for he U.S.) have an impac comparable in magniude o hose of emporary shocks. References Balassa, Bela, 1964, "The Purchasing Power Pariy Docrine: A Reappraisal," Journal of Poliical Economy 72: Canzoneri Mahew B., Rober E. Cumby and Behzad Diba, 1999, Relaive labor produciviy and he real exchange rae in he long run: evidence for a panel of OECD counries, Journal of Inernaional Economics 47 (2): Chinn, Menzie, 2000, The Usual Suspecs: Produciviy and Demand Shocks and Asia-Pacific Real Exchange Raes, Review of Inernaional Economics 8(1): Chinn, Menzie, 1999, Produciviy, Governmen Spending and he Real Exchange Rae: Evidence for OECD Counries, in Equilibrium Exchange Raes, edied by Ronald MacDonald and Jerome Sein (Boson: Kluwer Academic Publishers): Clarida, Richard and J. Gali, 1995, "Sources of Real Exchange Rae Movemens: How Imporan Are Nominal Shocks?" Carnegie-Rocheser Conference Series on Public Policy 41: 9-66.

6 DeGregorio, Jose and Holger Wolf, 1994, "Terms of Trade, Produciviy, and he Real Exchange Rae," NBER Working Paper #4807 (July). Dornbusch, Rudiger "Expecaions and Exchange Rae Dynamics." Journal of Poliical Economy 84: Engel, Charles, 1999, Accouning for US Real Exchange Rae Changes, Journal of Poliical Economy 107(3): Frankel, Jeffrey, 1979, "On he Mark: A Theory of Floaing Exchange Raes Based on Real Ineres Differenials," American Economic Review 69: Gagnon, Joseph, 1996, Ne Foreign Asses and Equilibrium Exchange Raes: Panel Evidence, Inernaional Finance Discussion Papers No. 574 (Washingon, D.C.: Board of Governors of he Federal Reserve Sysem). Hsieh, David, 1982, "The Deerminaion of he Real Exchange Rae: The Produciviy Approach," Journal of Inernaional Economics 12(2): Krueger, Anne O., 1983, Exchange-Rae Deerminaion (Cambridge, UK: Cambridge Universiy Press). Lane, Philip R. and Gian Maria Milesi-Ferrei, 2002, "Exernal Wealh, he Trade Balance, and he Real Exchange Rae," European Economic Review 46(6): Lee, Jaewoo and Menzie Chinn, forhcoming 2006, Curren Accoun and Real Exchange Rae Dynamics in he G-7 Counries, Journal of Inernaional Money and Finance. Lucas, Rober "Ineres Raes and Currency Prices in a Two-Counry World." Journal of Moneary Economics 10(3): Mark, Nelson and Doo Yull Choi, 1997, Real Exchange Rae Predicion over Long Horizons, Journal of Inernaional Economics 43: Rogoff, Kenneh, 1996, The Purchasing Power Pariy Puzzle, Journal of Economic Lieraure 34(2): Saler, Wilfred A., 1959, Inernal and Exernal Balance: The Role of Price and Expendiure Effecs, Economic Record 35: Samuelson, Paul, 1964, "Theoreical Noes on Trade Problems," Review of Economics and Saisics 46: Sockman, Alan, 1980, "A Theory of Exchange Rae Deerminaion." Journal of Poliical Economy 88(4):

7 Swan, Trevor, 1960, Economic Conrol in a Dependen Economy, Economic Record 36: Taylor, Alan M. and Mark P. Taylor, 2004, The Purchasing Power Pariy Debae, Journal of Economic Perspecives 18(4) (Fall): Williamson, John (edior), 1994, Esimaing Equilibrium Exchange Raes (Washingon, DC: Insiue for Inernaional Economics).