Working Paper: CEPR ID: DP209
Authors: Peter Neary
Abstract: This paper presents a compact derivation of the determinants of changes in the equilibrium real exchange rate (the price index of non-traded goods relative to traded goods) in a small open economy with any number of goods and factors. It is shown that the change in the real exchange rate equals a simple weighted sum of the differences between the marginal propensities to consume and the marginal propensity to produce individual non-traded goods. Implications of the result are noted for a variety of applied questions, including the effects of foreign aid, the "Dutch Disease", and cross-country comparisons of purchasing power parity.
Keywords: real exchange rate; dutch disease; purchasing power parity
JEL Codes: 411; 431
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| demand for nontraded goods (R22) | change in the equilibrium real exchange rate (F31) |
| supply of nontraded goods (H49) | change in the equilibrium real exchange rate (F31) |
| exogenous shock (F41) | demand for nontraded goods (R22) |
| exogenous shock (F41) | supply of nontraded goods (H49) |
| demand for nontraded goods increases significantly compared to supply (H49) | real appreciation of the exchange rate (F31) |
| foreign aid transfers (F35) | demand for nontraded goods (R22) |
| sector-specific booms (Q33) | demand for nontraded goods (R22) |
| increased demand for nontraded goods without corresponding supply increase (R22) | competitiveness loss in non-booming traded sectors (F12) |
| lower-income countries (F63) | relatively cheaper nontraded goods (H49) |
| differences in marginal propensities to consume and produce (E20) | purchasing power parity (F31) |