Accounting for real exchange rates in emerging economies: The role of commodity prices

Abstract

A puzzling feature of international price data is that real exchange rates are much more volatile than macroeconomic fundamentals. This study empirically disaggregates international prices into their component parts to examine the key sources of high real exchange rate volatility with emphasis on Emerging Market Economies (EMEs). Using quarterly data over 1985–2015 for 28 countries, we document that 1) relative tradeable goods prices account for most of the observed volatility, 2) world commodity prices explain about 30% of real exchange rate fluctuations, and 3) commodity price shocks are associated with large and persistent real exchange rate appreciations in EMEs. Our results underscore the importance of commodity prices for the conduct of exchange-rate policy in EMEs.