Do Relative Prices of Non-Traded Goods Determine Long-Run Real Exchange Rates?

Abstract

In this paper, the long-run assumptions of so-called equilibrium models of real exchange rates are investigated. The assumption of purchasing power parity for tradable goods, common to this class of models, implies that the real exchange rate is a function of the relative prices of nontraded goods in the two countries. While purchasing power parity for tradable goods is not directly testable, exploitation of wholesale and consumer prices allows for direct estimation of the reduced form. Cointegration tests are performed for twenty-one bilateral relationships. While much of the evidence is consistent with the predictions of equilibrium models, results are far from conclusive.