Abstract
The long and persistent swings in the real exchange rate have for a long time puzzled economists. Recent models built on imperfect knowledge economics seem to provide a theoretical explanation for this persistence. Empirical results, based on a cointegrated vector autoregressive (CVAR) model, provide evidence of error-increasing behavior in prices and interest rates, which is consistent with the persistence observed in the data. The movements in the real exchange rate are compensated by movements in the interest rate spread, which restores the equilibrium in the product market when the real exchange rate moves away from its long-run benchmark value. Fluctuations in the copper price also explain the deviations of the real exchange rate from its long-run equilibrium value.
Highlights
The purchasing power parity (PPP) theory establishes that identical goods will have the same price in different economies when prices are expressed in the same currency (Krugman et al 2011).In other words, the aggregate relative prices between two countries should be equal to the nominal exchange rate between them (Taylor and Taylor 2004).1The PPP has been broadly used in economics, in both theoretical models and empirical applications
This paper finds, based on the estimation of a cointegrated vector autoregressive (CVAR) model, that the long and persistent swings in the real exchange rate are compensated by movements in the interest rate spread, which restores the equilibrium in the product market when the real exchange rate moves away from its long-run benchmark value
The long and persistent swings of the real exchange rate have for a long time puzzled economists
Summary
The purchasing power parity (PPP) theory establishes that identical goods will have the same price in different economies when prices are expressed in the same currency (Krugman et al 2011). Empirical evidence shows that over time, the nominal exchange rate exhibits long and persistent swings around relative prices. While the ratio of domestic to foreign good prices changes slowly over time, the nominal exchange rate exhibits long and persistent swings away from its benchmark value. These persistent swings are observed in the real exchange rate. The fact that RER has acted as a shock absorber due to the flexible exchange rate regime, a rule-based fiscal policy, and a flexible inflation targeting system might explain why the Chilean economy has become increasingly resilient to copper price shocks in the last 25 years (De Gregorio and Labbé 2011).
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