Real Exchange Rates: Measurement and Implications for Predicting U.S. External Imbalances

Abstract

That international trade flows respond to changes in real exchange rates is beyond question. What is less clear is whether the measurement of real exchange rates matters for characterizing and predicting such responses. To identify the implications of choosing a given measure of the real exchange rate, I examine how the parameter estimates and the forecast performance of a given model vary in response to alternative measures of real exchange rates. I reject a given measure if its use (a) implies estimates inconsistent with economic theory; (b) contradicts the assumptions needed for statistical inference; (c) leads to systematic forecast errors; or (d) entails a loss of information relative to an alternative measure. Although the analysis rejects several measures of real exchange rates, it cannot identify a unique measure suitable for explaining U.S. trade: relative unit labor costs and relative consumer prices are equally suited for modeling and predicting U.S. trade.