Long-Run Determinants of the Real Exchange Rate - A Stock-Flow Perspective

Long-Run Determinants of the Real Exchange Rate:
A Stock-Flow Perspective, by Hamid Faruqee
This study investigates the sources of long-run movements in the real
exchange rate. For the United States and Japan, significant trends in their
real exchange rates remain as prominent stylized facts of the postwar era,
although the long-term drift in each case has been in opposite directions.
In the case of the United States, there has been a steady overall decline in
the real value of the dollar, whereas Japan has experienced extraordinary
real appreciation in the yen since World War II.

To account for long-run relative price movements, this paper implements a
version of the macroeconomic balance approach, emphasizing the stock-flow
determination of the real exchange rate compatible with internal and
external balance. Viewing purchasing power parity (PPP) as a fixed steady-
state condition rather than as a long-run equilibrium condition, the
analytical framework allows the long-run real exchange rate to be affected
by real disturbances--representing fundamental shifts in the relative prices
compatible with international equilibrium.

Using postwar data for the United States and Japan, cointegration analysis
is used to examine the long-run co-movements between the real exchange rate
and a set of fundamental determinants. Cointegration tests suggest a
deterministic long-run relationship between the structural components in the
current and capital accounts--underlying a country's net trade and net
foreign asset positions--and the real exchange rate for these countries.

Specifically, cointegration estimates provide strong evidence that
productivity differentials explain a significant portion of the trend
variation in the real value of both the dollar and the yen. For the United
States, there is also supporting evidence that the stock of net foreign
assets has had an impact on the long-run real exchange rate. In both cases,
there is little empirical support for the terms of trade determining the
long-run path. The empirical analysis also provides estimates for the
underlying stochastic trend in the real exchange rate for the United States
and Japan, conditional on the empirically relevant fundamentals.