Working Paper: NBER ID: w18331
Authors: Paul R. Bergin; Reuven Glick; Jyh-Lin Wu
Abstract: Long half-lives of real exchange rates are often used as evidence against monetary sticky price models. In this study we show how exchange rate regimes alter the long-run dynamics and half-life of the real exchange rate, and we recast the classic defense of such models by Mussa (1986) from an argument based on short-run volatility to one based on long-run dynamics. The first key result is that the extremely persistent real exchange rate found commonly in post Bretton Woods data does not apply to the preceding fixed exchange rate period in our sample, where the half-live was perhaps half as large. This result suggests a reinterpretation of Mussa's original finding, indicating that up to two thirds of the rise in variance of the real exchange rate in the recent period is actually due to the rise in persistence of the response to shocks, rather than due to a rise in the variance of shocks themselves. The second key result explains the rise in persistence over time by identifying underlying shocks using a panel VECM model. Shocks to the nominal exchange rate induce more persistent real exchange rate responses compared to price shocks, and these shocks became more prevalent under a flexible exchange rate regime.
Keywords: Real Exchange Rate; Purchasing Power Parity; Nominal Exchange Rate; Price Shocks; Panel Econometrics
JEL Codes: F15; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Bretton Woods period (F33) | halflife of the real exchange rate (F31) |
| post-Bretton Woods period (F33) | halflife of the real exchange rate (F31) |
| flexible exchange rates (F31) | variance of the real exchange rate (F31) |
| exchange rate regime (F33) | persistence of real exchange rate fluctuations (F31) |
| nominal exchange rate shocks (F31) | persistence of real exchange rate responses (F31) |
| price shocks (E30) | persistence of real exchange rate responses (F31) |