Persistence Of Real Exchange Rates Research Articles

Real exchange rate overvaluation and currency crisis: evidence from Thailand

This article examines real exchange rate (RER) misalignment in Thailand in the lead-up to the 1997–1998 currency crisis. The methodology involves estimating the long-run equilibrium RER based on the internal and external balance approach. RER misalignment is measured by comparing the actual RER with the estimated long-run equilibrium RER. The results suggest that there was a persistent RER overvaluation from 1991 up to the onset of the crisis in 1997. ‘Too much’ net short-term capital inflows and government expenditure expansion were the main contributory factors. After the massive depreciation of nominal exchange rate during the crisis, the RER seems to have gradually returned to its long-run equilibrium level.

Persistence in law of one price deviations: Evidence from micro-data

Using an extensive micro-price panel, we find a positive cross-sectional relationship between LOP persistence and the distribution margin, which we measure using sectoral U.S. data, as suggested by the classical dichotomy. The median level of persistence (across goods) is low, and there is no evidence of a border effect: the half-life of a deviation is about 19 months across OECD cities and just 1 month lower across cities in the U.S. Aggregating our micro-data using a variety of weighting methods shows PPP persistence to be in the range of 1–2 years, over the 1990–2005 period. These results challenge three widely held views: (i) the classical dichotomy is irrelevant; (ii) high persistence is a robust feature of aggregate real exchange rates; and (iii) border crossings necessarily generate greater real exchange rate persistence.

Accounting for Persistence and Volatility of Good-Level Real Exchange Rates: The Role of Sticky Information

Volatile and persistent real exchange rates are observed not only in aggregate series but also in the individual good level data. Kehoe and Midrigan (2007) recently showed that, under a standard assumption on nominal price stickiness, empirical frequencies of micro price adjustment cannot replicate the time-series properties of the law-of-one-price deviations. We extend their sticky price model by combining good specific price adjustment with information stickiness in the sense of Mankiw and Reis (2002). Under a reasonable assumption on the money growth process, we show that the model fully explains both persistence and volatility of the good-level real exchange rates. Furthermore, our framework allows for multiple cities within a country. Using a panel of U.S.-Canadian city pairs, we estimate a dynamic price adjustment process for each 165 individual goods. The empirical result suggests that the dispersion of average time of information update across goods is comparable to that of average time of price adjustment.

The Real Exchange Rate in Sticky Price Models: Does Investment Matter?

This paper re-examines the ability of sticky-price models to generate volatile and persistent real exchange rates. We use a DSGE framework with pricing-to-market akin to those in Chari, et al. (2002) and Steinsson (2008) to illustrate the link between real exchange rate dynamics and what the model assumes about physical capital. We show that adding capital accumulation to the model facilitates consumption smoothing and significantly impedes the model's ability to generate volatile real exchange rates. Our analysis, therefore, caveats the results in Steinsson (2008) who shows how real shocks in a sticky-price model without capital can replicate the observed real exchange rate dynamics. Finally, we find that the CKM (2002) persistence anomaly remains robust to several alternative capital specifications including set-ups with variable capital utilization and investment adjustment costs (see, e.g., Christiano, et al., 2005). In summary, the PPP puzzle is still very much alive and well.

The Real Exchange Rate in Sticky Price Models: Does Investment Matter?

This paper re-examines the ability of sticky-price models to generate volatile and persistent real exchange rates. We use a DSGE framework with pricing-to-market akin to those in Chari et al. (2002) and Steinsson (2008) to illustrate the link between real exchange rate dynamics and what the model assumes about physical capital. We show that adding capital accumulation to the model facilitates consumption smoothing and significantly impedes the model’s ability to generate volatile real exchange rates. Our analysis, therefore, caveats the results in Steinsson (2008) who shows how real shocks in a sticky-price model without capital can replicate the observed real exchange rate dynamics. Finally, we find that the Chari et al. (2002) persistence anomaly remains robust to several alternative capital specifications including set-ups with variable capital utilization and investment adjustment costs (see, e.g., Christiano et al., 2005). In summary, the PPP puzzle is still very much alive and well. JEL Classification: F31, F41, F42

Further on nonlinearity, persistence, and integration properties of real exchange rates

Integration, nonlinearity, and persistence dynamics of several quarterly US-Dollar-denominated real exchange rates are investigated by using new unit root tests, simulated p-values for linearity tests, estimation of smooth transition autoregressive (STAR) models, and simulation of autocorrelation functions. This paper uses a simulation-based approach to study covariance stationarity and persistence dynamics of the estimated models. Findings in the paper provide evidence of nonlinear mean reversion for several series albeit with some persistence. Results also reveal considerable variation in the degree of persistence and timing of switches across extreme regimes in ESTAR models between Euro and non-Euro area currencies.

Persistent Appreciations and Overshooting: A Normative Analysis

Most economies experience episodes of persistent real exchange rate appreciations, when the question arises whether there is a need for intervention to protect the export sector. In this paper we present a model of irreversible destruction where exchange rate intervention may be justified if the export sector is financially constrained. However the criterion for intervention is not whether there are bankruptcies or not, but whether these can cause a large exchange rate overshooting once the factors behind the appreciation subside. The optimal policy includes ex-ante and ex-post interventions. Ex-ante (i.e., during the appreciation phase) interventions have limited effects if the financial resources in the export sector are relatively abundant. In this case the bulk of the intervention takes place ex-post, and is concentrated in the first period of the depreciation phase. In contrast, if the financial constraint in the export sector is tight, the policy is shifted toward ex-ante intervention and it is optimal to lean against the appreciation. On the methodological front, we develop a framework to study optimal dynamic interventions in economies with financially constrained agents.

Volatile and persistent real exchange rates with or without sticky prices

The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. Two methodologies are employed to explore this model's ability to generate volatile and persistent exchange rates. In the first, actual data is used for the exogenous driving processes. In the second, the model is simulated using estimated forcing processes. The theory, in both cases, is capable of explaining the high volatility and persistence of real and nominal exchange rates as well as the high correlation between real and nominal rates.

The Contribution of Growth and Interest Rate Differentials to the Persistence of Real Exchange Rates

This paper employs a new methodology for measuring the contribution of growth and interest rate differential to the half-life of deviations from Purchasing Power Parity (PPP). Our method is based on directly comparing the impulse response function of a VAR model, where the real exchange rate is Granger caused by these variables with the impulse response function of a univative ARMA model for the real exchange rate. We show that the impulse response function of the VAR model is not, in general, the same with the impulse response function obtaianed from the equivalent ARMA representation. If the real exchange rate is Granger caused by other variables in the system. The difference between the two functions captures the effects of the Granger-causing variables on the half-life of deviations for PPP. Our empirical results for a set of four currencies suggest that real and nominal long term interest rates differentials and real GDP growth differentials account for 22% to 50% of the falf-life of deviations from PPP.

Non-Linear Adjustment in Law of One Price Deviations and Physical Characteristics of Goods

At a level of individual goods, heterogeneity of marginal transaction costs, proxied by price-to-weight ratios and stowage factors, explains a large part of the variation in thresholds of no-adjustment and conditional half-lives of law of one price deviations. Prices of heavier (more voluminous) goods deviate further before becoming mean-reverting. Moreover, after becoming mean-reverting, prices of heavier goods converge more slowly. Together with measures of pricing power, market size, distance, and exchange rate volatility, these factors explain up to 43% of variation in no-adjustment threshold estimates across 52 goods in US-Canada post-Bretton Woods monthly CPI data and are robust in a broader five-country dataset. They open two avenues for the importance of marginal transaction costs in accounting for real exchange rate persistence: through (a) generating persistence in individual real exchange rate components, and (b) accentuating it by the aggregation of heterogeneous components (“aggregation bias” of Imbs et al., 2005a).

Nominal rigidity, desired markup variations, and real exchange rate persistence

This paper develops and estimates a dynamic general-equilibrium sticky-price model that accounts for real exchange rate persistence. The key feature of the model is the dependence of the firm's desired markup on its relative price. Desired markup variations exacerbate the nominal rigidity that results from the exogenously imposed frictions in the goods market. The model is estimated by the maximum-likelihood method using Canadian and U.S. data. The estimated model successfully replicates the properties of the Canada–U.S. bilateral real exchange rate. In particular, the model closely matches the persistence found in the real exchange rate series. More importantly, this is achieved with a plausible duration of price contracts and a moderate convexity of the demand function.

Real exchange rate persistence and monetary policy rules

The objective of this paper is to analyze the effects of alternative monetary rules on real exchange rate persistence. Using a two-country stochastic dynamic general equilibrium with nominal price stickiness and local currency pricing, we will show how the persistence of purchasing power parity deviations can be related to a monetary theory of these deviations. When monetary policy lean against the wind, there is no relationship of proportionality between the time during which prices remain sticky and the persistence of the response of the real exchange rate: in this case high nominal price rigidity is not sufficient, per se, in generating any persistence following a monetary shock. Moreover, we emphasize the role of interest rates smoothing policies and relative price stickiness within countries in understanding the relationship between the real exchange rate and monetary shocks. With reasonable parameters values, a wide range of monetary policy rules can generate real exchange rate autocorrelations around the ones observed in the data.

Real Exchange Rate Persistence and Systematic Monetary Policy Behaviour

This paper estimates forward-looking monetary policy rules for Germany over the 1979-98 period and for the United Kingdom for the periods 1979-90 and 1992-98. The estimation results indicate that there were substantial differences between systematic monetary policy in Germany and in the United Kingdom, as well as shifts in systematic monetary policy in the United Kingdom, over this period. The paper analyses the implications of these estimated policy rules for real exchange rate behaviour in an open economy dynamic stochastic general equilibrium model. The analysis shows that real exchange rate persistence could be attributed to the persistence of real shocks and interest rate smoothing behaviour of central banks. However, the observed cross-country asymmetry in systematic monetary policy behaviour elevates real exchange rate persistence to realistic levels, whereas changes in asymmetric policy behaviour alter the character of real exchange rate persistence.

Can Sticky Prices Account for the Variations and Persistence in Real Exchange Rates?

Can Sticky Prices Account for the Variations and Persistence in Real Exchange Rates?

Sectoral adjustment costs and real exchange rate dynamics in a two-sector dependent economy

This paper develops a two-sector model in which intersectoral capital movements involve adjustment costs, expressed as capital lost in the transformation process. These costs have important consequences for the dynamics of capital accumulation and particularly for real exchange rate dynamics. Persistent deviations of the real exchange rate from its equilibrium are derived and for plausible values of the adjustment cost parameters are consistent with the observed degree of real exchange rate persistence. For low adjustment costs the dynamics are qualitatively similar to those of the standard Heckscher–Ohlin technology. For high adjustment costs, the model converges to the specific-factors model. Thus our framework includes these two standard models as polar extremes.

Parity reversion persistence in real exchange rates: middle income country case

This article investigates purchasing power parity (PPP) in the specific context of middle income countries. To circumvent the low power of traditional stationarity tests (Augmented Dickey-Fuller and Phillips-Perron tests), it performs variance ratio and fractional integration tests in addition to Perron's test that accounts for potential structural changes in real exchange rate processes. Beyond estimating half-life shocks to PPP, this article attempts to explain these estimates using a set of country specific variables as suggested by economic theory. The evidence suggests that reversion to parity tends to be faster in high inflation countries and that productivity improvement leads to a higher level of persistence. Openness to trade tends to reduce the extent of deviations from parity but this result does not appear to be statistically robust. Evidence shows also that deviations are less persistent under a fixed exchange rate regime and under unrestricted capital mobility.

PPP Strikes Back: Aggregation and the Real Exchange Rate

We show the importance of a dynamic aggregation bias in accounting for the PPP puzzle. We prove that established time-series and panel methods substantially exaggerate the persistence of real exchange rates because of heterogeneity in the dynamics of disaggregated relative prices. When heterogeneity is properly taken into account, estimates of the real exchange rate half-life fall dramatically, to little more than one year, or significantly below Rogoff's consensus view of three to five years. We show that corrected estimates are consistent with plausible nominal rigidities, thus, arguably, solving the PPP puzzle.

PPP Strikes Back: Aggregation and the Real Exchange Rate

We show the importance of a dynamic aggregation bias in accounting for the PPP puzzle. We prove that established time series and panel methods substantially exaggerate the persistence of real exchange rates because of heterogeneity in the dynamics of disaggregated relative prices. When heterogeneity is properly taken into account, estimates of the real exchange rate half-life fall dramatically, to little more than one year, or significantly below Rogoff's consensus view of three to five years. We show that corrected estimates are consistent with plausible nominal rigidities, thus, arguably, solving the PPP puzzle.

PPP Strikes Back: Aggregation And the Real Exchange Rate

We show the importance of a dynamic aggregation bias in accounting for the PPP puzzle. We prove that the aggregate real exchange rate is persistent because its components have heterogeneous dynamics. Established time series and panel methods fail to control for this. Using Eurostat data, we find that when heterogeneity is taken into account, the estimated persistence of real exchange rates falls dramatically. Its half-life, for instance, may fall to as low as eleven months, significantly below the consensus view of three to five years.

Why is it so difficult to beat the random walk forecast of exchange rates?

Recent empirical evidence suggests that the time series behavior of the real exchange rate is well approximated by a nonlinear, exponential smooth transition autoregressive (ESTAR) model. This nonlinearity helps resolve a number of puzzles concerning the persistence and volatility of real exchange rates. In this paper, we explore whether it may also help resolve the well-known difficulties of exchange rate forecasting. We develop a bootstrap test of the random walk hypothesis of the nominal exchange rate, given ESTAR real exchange rate dynamics. We find strong evidence of predictability at horizons of 2 to 3 years, but not at shorter horizons.