BOFIT Discussion Papers, Institute for Economies in Transition, Bank of Finland
No 1/2014:
Determinants of real exchange rates: An empirical investigation
Vikas Kakkar ()
and Isabel Yan ()
Abstract: The large and persistent deviations of nominal exchange
rates from their purchasing power parities comprise a key stylized fact in
international economics. This paper sheds light on these persistent
deviations by combining two disparate strands of empirical work. The first
strand focuses on real economic shocks such as sectoral technology shocks
suggested by the celebrated Balassa-Samuelson model, whereas the second
strand emphasizes monetary shocks which create persistent effects on both
the real interest rate and the real exchange rate. We also hypothesize a
third factor which may affect real exchange rates – shocks to the global
financial system, which we proxy by the real price of gold.
Although
each factor in isolation has limited explanatory power, we find that these
three factors in conjunction can successfully explain the medium to long
run move-ments in 14 bilateral U.S. dollar real exchange rates from 1970 to
2006. The three factors are sectoral total factor productivity
differentials, real interest rate differentials, and the real price of
gold, representing real shocks, monetary shocks, and shocks to the global
financial system, respectively. We document evidence suggesting that
bilateral U.S. dollar real ex-change rates are cointegrated with these
three factors.
Keywords: purchasing power parity; Balassa-Samuelson model; cointegration; (follow links to similar papers)
JEL-Codes: F31; F41; (follow links to similar papers)
27 pages, January 8, 2014
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