The Role of Real Shocks in Determining Real Exchange Rates: The Evidence

Abstract

This chapter presents an empirical analysis of the role of real forces affecting the real exchange rates of several advanced industrial countries with respect to the United States – in particular, Canada, the United Kingdom, Japan, France and Germany. The task is to try to determine the extent to which observed real exchange rate changes are a consequence of real shocks to technology and capital accumulation. The lack of useful models of technological change makes this a difficult undertaking. One can only attempt to discern whether observed real exchange rate movements can be ‘explained‘ by factors such as income growth, terms of trade changes, world oil and commodity price changes, shifts in world investment, and differential changes in government activity, that would obviously be expected to influence countries’ real exchange rates. The real exchange rates with respect to the United States of Canada, the United Kingdom and Japan will be examined for the period 1974 through 2007. The real exchange rate of France with respect to the United States will be examined for the period 1974 through 1998, and that of Germany for the period 1974 through 1988. The sample periods for both France and Germany are shortened to end with European exchange market unification and the German analysis is further restricted to avoid data complications resulting from the merging of East Germany with West. All data are quarterly and explained in detail in Appendix F. The focus of this chapter will be entirely on real shocks with monetary shocks being the subject of the two chapters that follow. The analysis begins with the Canada/U.S. real exchange rate { it turns out that a full understanding of all the measurement and identification problems that arise with respect to all the real exchange rates examined can be best achieved by detailed study of this case.