The response of real exchange rates to various economic shocks.

• Author: Zhou, Su

1. Introduction

   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 an appreciation of the faster-growing country's currency in real terms [4]. It is also argued that fiscal variables might be important in explaining the fluctuations in real exchange rates [23].

   Although we expect that the real factors listed above may have influences on the real exchange rates, the questions of how significant the influences are and whether the influences are persistent in the long run have not been well addressed. In the theoretical literature, the determination of the nominal and real exchange rates has been extensively studied, but there have been only a limited number of efforts at empirically studying the sources of fluctuations in the real exchange rates [15; 2; 34; 43].

   The present paper offers an investigation of the sources of movements of the real exchange rates. The study focuses on the stochastic trend movements of the real exchange rates. Since most of the relevant variables are nonstationary, which we will verify later, it seems appropriate to employ some recent advances in time series analysis, including the cointegration tests and the common stochastic trend approach. These new econometric techniques are applied to deal with the problem of nonstationarity in the data series and to test how real exchange rates react to changes in real variables, such as the world real price of oil, the productivity differentials, and the domestic and foreign fiscal variables, as well as to changes in nominal variables, such as the differentials of monetary bases. By including a monetary variable in the model, we may empirically test the hypothesis of the long-run neutrality of money, rather than assuming it holds. If the results verify that money is neutral in the long run, it may suggest limited effectiveness of the monetary policy designed to affect real economic activities.

   The model developed in the study is applied to the real yen-dollar rate ([RER.sub.[yen]/$]) and the real markka-dollar rate ([RER.sub.FM/$]). The former is the relative real value of the two major currencies, while the latter is the real value of the currency of a small open economy, Finland, relative to the U.S. dollar. Discussions about the possible differences and similarities of the two rates in their response to various shocks will be given in the next section. Choosing these two rates may allow us to show the general applicability of the method employed in this study under different circumstances and provide more insights to our understanding of the real exchange rate movements.

   The issue of what cause fluctuations in the yen-dollar rate has drawn much attention. Ohno [34] studied the mechanism of long-run mean reversion of the real yen-dollar rate by using the vector autoregressive model, but he did not take care of the possible problem of nonstationarity in the variables in his study. Lastrapes [26] offered an investigation of the sources of fluctuations in real and nominal exchange rates using only information contained in the exchange rates and price indices. His study led to the conclusion that "fluctuations over the current flexible rate period in real and nominal exchange rates are due primarily to real shocks" [26, 538] but did not explain what kind of real shocks are important. Yoshikawa [43] carefully examined the relative importance of different real factors in affecting the long-run trend of the nominal yen-dollar rate. Our study is different from Yoshikawa's by (a) focusing on the real yen-dollar rate, (b) applying some new methods in time series analysis to the investigation and (c) including the fiscal variables in the real factors, which may influence the movement of the real exchange rate, in the study. In contrast to the relatively rich literature of the yen-dollar rate, the study of the Finnish exchange rate is rather scarce. Our study may help to fill this gap in the literature.

   The remaining part of the paper is organized as follows. Section II discusses some theoretical issues of the study. Section III lays out the methodology employed. In section IV, we apply the empirical model to the two real exchange rates. The results are reported and analyzed in the same section. The last section gives conclusions of this study.

2. Theoretical Issues

   In this study, five variables are considered to have influence on the bilateral real exchange rates. They are the world real price of oil, the domestic and U.S. government consumption spending/ GDP ratios, the productivity differential and monetary differential between the two countries. We now briefly demonstrate how these variables may affect the movement of the real exchange rate.

   The real exchange rate (RER) between two currencies is measured in terms of overall price levels,

   RER = [e.sub.d/f] + [p.sup.f] - [p.sup.d] (1)

   where [e.sub.d/f] is the log of nominal exchange rate (domestic currency price of foreign exchange). [p.sup.d] and [p.sup.f] are the logs of price indices of the two countries that encompass both tradable and non-tradable sectors. We then express the exchange-rate-adjusted relative price of foreign and domestic tradable goods as

   [Mathematical Expression Omitted]

   where [Mathematical Expression Omitted] and [Mathematical Expression Omitted] are the logs of domestic and foreign prices of tradable goods respectively. We assume

   [Mathematical Expression Omitted],

   [Mathematical Expression Omitted],

   where [Phi]'s are the share parameters of tradable goods. [Mathematical Expression Omitted] and [Mathematical Expression Omitted] are the logs of domestic and foreign prices of non-tradable goods respectively. Substituting (2), (3a), and (3b) into (1), we get

   [Mathematical Expression Omitted].

   Therefore, if [[Phi].sup.d] is similar to [[Phi].sup.f], a rise in the relative price of domestic tradable, [Mathematical Expression Omitted], by a bigger proportion than the change in the relative price of foreign tradable [Mathematical Expression Omitted], would cause a rise in the real exchange rate measured by (1). Moreover, home and foreign traded goods are likely imperfect substitutes. If an exogenous shock results in higher exchange-rate-adjusted prices of foreign tradable products relative to the prices of domestic tradable goods (i.e., a higher [Mathematical Expression Omitted]), a real depreciation of the home currency (i.e., a rise in RER) would occur.

   Differential of Productivity Growth

   Balassa [4] first noted the systematic tendency for productivity to grow more rapidly in tradable than non-tradable sectors, and for this differential to be greater in faster-growing countries. The relative price of non-traded commodity in terms of traded goods will thus be higher in the faster-growing country than in the others. Therefore, if one measures the real exchange rate by multiplying the nominal exchange rate by the ratio of the two countries' price indices that encompass both tradable and non-tradable sectors, the currency of the faster-growing country will appear to have appreciated even if the prices of tradable goods would be equalized in the two countries through international exchanges. That is, a country having a faster productivity growth would experience a lower [Mathematical Expression Omitted]. This may lead to a real appreciation of the home currency, a lower RER.

   World Real Price of Oil

   The link between the price of oil or energy and exchange rate dynamics has been noted by Krugman [24], McGuirk [32], Yoshikawa [43], and a number of other researchers. The influence of the oil price on the bilateral real exchange rate relies on the difference of the two relevant countries in their dependence on imported oil. Japan and Finland are more heavily dependent on imported oil than the U.S. is...