Stochastic trends and economic fluctuations in a large open economy

Abstract

This study examines the role of stochastic trends in real exchange rates and foreign output in explaining economic fluctuations in the United States. While many of the results are consistent with recent closed-economy studies, the evidence shows that external shocks have significant short-run effects on economic fluctuations, even in a large country. A real appreciation of the dollar leads to permanent decreases in net exports and temporary decreases in output. Permanent shocks to real exchange rates have surprisingly large effects on output over the course of the normal business cycle.