External Shocks, Purchasing Power Parity, and the Equilibrium Real Exchange Rate

Abstract

Two approaches are commonly used to determine the equilibrium real exchange rate in a country after external shocks: purchasing power parity (PPP) calculations and the Salter-Swan, tradables-nontradables model. There are theoretical and empirical problems with both approaches, and tensions between them. In this article the authors resolve these theoretical and empirical difficulties by presenting a model which is a generalization of the Salter-Swan model and which incorporates imperfect substitutes for both imports and exports. Within the framework of this model, the definition of the real exchange rate is consistent both with that of the PPP approach and with that of the Salter-Swan model (suitably extended). The model, however, is capable of capturing a richer set of phenomena, including terms of trade shocks and changes in foreign capital inflows. It also provides a practical way to estimate changes in the equilibrium real exchange rate, requiring little more information than is required to do PPP calculations. The results are consistent with those of multisector computable general equilibrum models, which generalize the trade specification of the small model.