What do We Really Know about Real Exchange Rates?

Abstract

This paper attempts to provide a comprehensive overview of the recent literature on the economics of real exchange rates. Since the rapid growth of this literature has been due to the development and application of econometric and statistical techniques, rather than to any new theoretical developments, the main focus of this paper is empirical. One way of motivating the material discussed here is to refer to the observed close correlation between real and nominal exchange rates during the recent floating experience, as illustrated in Figure 1. Indeed, it has become something of a stylised fact that the correlation between real and nominal exchange rates is very close to unity. Given the evident variability of real exchange rates, the immediate implication of this is that PPP cannot hold continuously and, in particular, in the short-run. But does it hold at all, and especially in a long-run context? There is some evidence to suggest that it does not, so one important theme in any discussion of real exchange rates concerns trying to quantify the importance of relative prices in explaining nominal exchange rate movements. As we shall see, much of this debate focuses on the magnitude of mean reversion in real exchange rates and, in particular, explaining why it is so slow. A related issue concerns unravelling the sources of the close correlation between real and nominal rates. Do nominal exchange rates drive real rates, or does causality run in the opposite direction?