Exchange Rate Economics: Theories and Evidence

218 Real exchange rate determination
exchange rate is influenced by monetary shocks. The short run level of demand
determined output can be generated by substituting (8.46) into (8.34) to get:
y ′ t = y s′
t + (η + σ)v(1 − θ)(v t − z t + αγδ t ). (8.47)
As expected,with sluggish price adjustment demand and monetary shocks,in
addition to supply shocks,influence y t in the short run. Although all three shocks
influence all three variables in the short run,the long-run response of the y, q
and p is triangular. That is,only the supply shock influence the long-run level of
relative output; supply and demand shocks influence the long-run level of the real
exchange rate; and all three shocks influence the long-run level of prices at home
and abroad.
Clarida and Gali (1994) use an SVAR approach to estimate the stochastic version
of the open economy MFD model discussed above. As in that model,the three
key variables modelled are the change in relative output levels,the change in the
real exchange rate and a relative inflation rate (changes are used to address the
non-stationarity of the level of output,the real exchange rate and the price level)
and more specifically,let
x t ≡[y t , q t , π t ] ′ ,(8.48)
where the estimated covariance matrix, ,will have dimensions 3 × 3. Assuming
the shocks are mutually orthogonal and normalising the n diagonal elements to
be unity,the remaining 3(= n(n − 1)/2) restrictions on C 0 may be obtained by
assuming it is lower triangular:
⎡
⎤
c 11 0 0
C 0 = ⎣c 21 c 22 0 ⎦.
c 31 c 32 c 33
Bearing in mind the ordering of the variables in (8.48),this amounts to only the
first shock,which is labelled a supply shock,having a long-run effect on all three
variable,the second shock,labelled the demand shock,having a long-run effect on
both the real exchange rate and relative inflation and the third shock,the nominal
or monetary shock,only having and effect on the relative inflation term. This lower
triangular representation of course follows from the stochastic version of the MFD
model considered above. The 3 × 1 vector of structural shocks is:
e t ≡[z t , δ t , v t ] ′ ,(8.49)
where z t represents the supply shock, δ t is the demand shock and v t is the nominal
shock.
The expected sign patterns of the real shock on output,the real exchange rate
and the price level generated by the MFD model are as follows. A permanent
demand shock should permanently appreciate the currency,increase the price
level and output in the short run. A supply shock should produce a depreciation of