Explaining exchange rate behavior.

• Author: Chinn, Menzie D.
• Position: Research Summaries

In an era characterized by increasingly integrated national economies, the exchange rate is the key relative price in open economies. As such, a great deal of attention has been focused on characterizing its behavior. Unfortunately, it is unclear how much success there has been in predicting this critical relative price. As recently remarked, "There may be more forecasting of exchange rates, with less success, than almost any other economic variable." (1) While this characterization may be quite apt -- a point I will return to later -- it should not prevent us from attempting to identify the empirical determinants of exchange rates, an enterprise separate from forecasting exchange rates.

The Impact of Productivity Changes

The first major line of inquiry I've followed links changes in productivity to changes in nominal and real exchange rates. There is a long and venerable literature that links these two variables theoretically, most notably associated with Balassa and Samuelson. (2) In these models, differences in productivity levels between traded and nontraded sectors affect the relative prices of these goods. Further, with traded goods prices equalized in common currency terms, real exchange rates -- which incorporate the prices of nontraded good -- will be affected.

The post-War yen has been the traditional candidate for explanation by this type of model. (3) In addition, the model typically is applied to economies experiencing rapid growth, since such growth often is associated with rapid productivity change in the tradable (manufacturing) sector. Hence, a natural application of the model is to the East Asian countries. Unfortunately, the data necessary for a direct test of the model do not readily exist. Instead, most analyses rely on observations on relative prices to infer the validity of the approach. In order to conduct a direct test, I compiled sector-specific employment and output data for China, Indonesia, Japan, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand, and estimated the implied relationships. The time-series evidence did not support the model except in a few cases. Using panel regression techniques adapted to persistent time series, (4) I find that the model applies to the set of countries including Indonesia, Japan, Korea, Malaysia, and t he Philippines. (15) Part of the reason for the limited extent of the finding may be that measured traded goods prices do not appear to be equalized, especially when the prices pertain to bundles of goods that are changing rapidly. After all, the composition of exports of Malaysia today bears little resemblance to that of forty years ago.

Interestingly, there is some evidence that the productivity effect applies even for more developed economies. Louis D. Johnston and I examined sector-specific productivity levels for 14 OECD countries. Using panel cointegration methods, we found that productivity levels did matter for dollar-based real exchange rate levels in the long run, although other factors mattered as well. These other factors included government spending and the terms of trade. In a closely related paper, we found that the same conclusions held for trade-weighted OECD real exchange rates. (16)

More recently, Ron Alquist and I have examined the behavior of the euro/dollar exchange rate, drawing inspiration from the large literature that ascribed the strength of the dollar and the weakness of the euro to the differing prospects for accelerated productivity growth rates associated with the diffusion of the New Economy. Using aggregate productivity data from 1985 to 2001, we found that productivity was strongly related to the euro/dollar rate. One of the paradoxes of the results is that according to the estimates, each one percentage point increase in the productivity differential between the United States and the eurozone economies results in a real dollar appreciation of between 2 and 5 percent. While other studies have detected effects of a similar nature, the magnitude is somewhat larger than has been found previously. Furthermore, it is hard -- although not impossible -- to rationalize the magnitude of the effect theoretically. A combination of demand side effects and an increase in productivity, localized to the technologies used in the United States, is one interpretation. (17)

Overvaluation

Models of purchasing power parity, or the Balassa-Samuelson hypothesis, naturally lend themselves to the exercise of determining whether a currency is "overvalued" or otherwise misaligned. Indeed, one implication of the Balassa-Samuleson hypothesis is that the...