Exchange Rate Economics: Theories and Evidence

8 Real exchange rate
determination
Theory and evidence
In this chapter we move away from the long-run exchange rate framework
provided by PPP and the monetary model to a more eclectic exchange rate model,
which combines both real and nominal factors. In particular,we have seen from
our discussion of the recent literature on PPP that it takes about 8 years for a
deviation from PPP to be extinguished. As we noted in Chapter 3,part of the
explanation for this slow mean reversion might lie in the existence of transportation
costs which introduce non-linear thresholds. An alternative explanation is that
there may be ‘real’ factors (one of these being the Balassa–Samuelson effect,considered
in Chapter 2) which introduce systematic variability into the behaviour of
real and nominal exchange rates and in this chapter we examine some recent work
which seeks to model this systematic variability. Also considered in this chapter
are a number of other issues relating to real exchange rates such as real exchange
rate volatility and real interest rate parity.
This chapter has four main sections. In Section 8.1 we present a model,due
to Mussa (1984) and Frenkel and Mussa (1986),which neatly introduces some of
the key determinants of exchange rates when PPP does not hold continuously.
We refer to this model as an eclectic exchange rate model (EERM) because it
combines elements of the asset market approach considered in Chapters 4–7,
along with traditional balance of payments characteristics and forward-looking
expectations. In Section 8.2 we present some empirical estimates of exchange rate
models,starting with the real interest parity condition and then moving on to
some direct estimates of the EERM model and variants of this model. Finally,in
Section 8.3 we present an overview of the literature that seeks to decompose real
exchange rates into permanent and transitory components and,relatedly,real and
nominal sources. The main objective of this literature is to assess if the source of
real exchange rate volatility lies in the assymetrical adjustment between goods and
asset markets (asset markets adjust instantly while goods markets adjust slowly),as
suggested by Dornbusch (1976) and others,or if it is real shocks which drive the
real exchange rate,along the lines suggested by Stockman (1988).
8.1 An eclectic real exchange rate model
In this section we discuss a model of the exchange rate which combines asset market
attributes with traditional balance of payments characteristics. The model may be