Can sticky prices account for the variations and persistence in real exchange rates?

Abstract

This paper provides an empirical assessment of the importance of sticky prices in accounting for the variations and the persistence in real exchange rates. Vector autoregressions with five variables from two countries that always include the United States are estimated. Restrictions are imposed to identify a global shock, and two sets of country specific output shocks. One set of shocks is associated with instantaneous price adjustments, while the other has delayed effects on prices. Data from the G7 countries reveal that US sticky price shocks are the dominant source of real exchange rate variations. But these shocks have reasonably short half-lives and cannot account for the observed real exchange rate persistence. Non-sticky price shocks can induce very persistent real exchange rate dynamics, even though they account for little of the historical real exchange rate variations.