In international finance, the competing hypothesis that the logarithms of real exchange rates appear to be well-described as random walks during a period of floating rate, has found some support. Studies by Adler and Lehmann [2], Hakkio [12] and Mark [18] are examples of work supporting this view. If a real exchange rate process has been approximated to be non-stationary it implies there is little tendency for the real exchange rate to be mean-reverting, and also that deviations from the purchasing power parity (PPP) are permanent. Modern models of exchange rate determination suggest that real shocks can induce permanent changes in the real exchange rate. Stockman [21] pointed out that according to the approach, the behavior of real exchange rates since the collapse of Bretton Woods could reflect, not the importance of sluggish price-level adjustment, but rather the influence of real shocks with significant permanent components. Moreover, the evidence in Campbell and Clarida [5] and Huizinga [13] suggests that real exchange rates contain both permanent and transitory components, with most of their variation explained by the permanent components. However recent studies employing long-run data, or more powerful tests, tend to confirm the PPP hypothesis. Studies by Abuaf and Jorion [1], Kim [16], Whitt [22] and Diebold, Husted, and Rush [7] are four such examples. Their evidence shows that real exchange rates are stationary, which implies that the behavior of real exchange rates are influenced by transitory nominal disturbances. Hence, the validity of PPP remains at issue. Identifying the sources of exchange rate fluctuations is important not only for establishing the validity of PPP but also for achieving successful exchange rate stabilization. Attempts to stabilize exchange rate changes that are due to economic fundamentals could be futile and even harmful to the economy. In addition, measuring the relative importance of permanent and transitory shocks on exchange rates is essential for exchange rate modeling. If exchange rates are dominated by real shocks then the equilibrium approach offered by Stockman [21] is appropriate in analyzing the behavior of exchange rates. Conversely, if the evidence suggests the contrary, then the disequilibrium approach of Dornbusch [8] should be considered as an alternative. As a consequence,