Exchange Rate Economics: Theories and Evidence

Real exchange rate determination 213
Clarida and Gali (1994) present both univariate and multivariate (the latter are
generated from a trivariate VAR consisting of the change in the real exchange
rate,the change in output and the inflation rate) BN decompositions of the real
exchange rates of Germany,Japan,Britain and Canada. On the basis of the
average univariate results,it would seem that around 0.8% of the variance of
the real exchange rate is permanent and only 0.2% is transitory. Interpreting
the latter as the business-cycle-related component implies that only a very small
percentage of individual country real exchange rate movements are business cycle
driven. However,for Germany and Japan the picture changes quite dramatically
when the multivariate decompositions are used: now for Germany and Japan
0.7% and 0.6%,respectively,of the variance of the real exchange rate change is
due to transitory,or business cycle,components. Clarida and Gali attribute this
difference to the fact that in the $–DM and $–Yen systems,inflation has significant
explanatory power,in a Granger causality sense,over and above past values of
lagged real exchange rate changes and lagged output changes.
Baxter (1994) also reports univariate and multivariate BN decompositions for
a number of currencies,and on the basis of the univariate tests she finds that the
permanent component of the real exchange rate always exceeds the transitory
component and it is greatest in the case of the pound–dollar (this is consistent with
the Clarida and Gali analysis which also finds the pound sterling has the largest
permanent component). However,her multivariate decompositions – consisting
of the real exchange rate and inflation differential – reveal that the transitory component
dominates in three of the currency pairings. The finding that the transitory
component is much greater in the multivariate decompositions is in accord with
Clarida and Gali. Baxter (1994) also presents correlations of the permanent and
transitory components across countries. For the univariate models all of the permanent
components are strongly correlated across countries (having correlation
coefficients in excess of 0.5),but the transitory components show no such clear-cut
pattern; some are positively correlated (German mark–Swiss franc and French
franc–Swiss franc),but most are zero or negative. The multivariate correlations,
however,reveal much stronger evidence of positive correlations across countries;
interestingly,the only currency pairings to produce negative correlations are those
involving sterling. So on the basis of the multivariate results there is much more
evidence of an international business cycle.
Campbell and Clarida (1987) apply an unobserved components model to the
real exchange rate–real interest rate model (8.20) and extract the permanent and
transitory components. They demonstrate that the majority of movements in the
real exchange rate (at least 79%) are driven by movements in the permanent
component of the real rate and the remainder due to the transitory element.
In sum,univariate decompositions of real exchange rates into permanent and
transitory components indicate the dominance of permanent elements,although
multivariate representations give a far more even split between the two components.
Since the univariate results exclude information which may be an important
determinant of real exchange rates,we believe that the multivariate results
give a more accurate picture of the importance of the business cycle in driving