Real Exchange Rate and External Balance: How Important Are Price Deflators?

IMF Working Papers, March 30, 2017

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The choice of deflator plays a significant role in RER movements.
An empirical investigation based on 35 developed and emerging market economies over 1995 to 2014 yields comprehensive and robust evidence that only the RER deflated by ULC exhibits contemporaneous patterns consistent with the expenditure-switching mechanism.
A simple model featuring nominal rigidity and trade in intermediate goods (as in Obstfeld (2001) and Devereux and Engel (2007)) is shown to generate qualitatively identical patterns to the empirical findings.

Model features:
- Nominal rigidity.
- Trade in intermediate goods.
The modeled mechanism reproduces the qualitative patterns observed empirically, providing a theoretical rationale for why ULC-based RER measures align with expenditure-switching.

Measurement: Researchers and policymakers should be aware that different deflators (CPI, GDP deflator, ULC) can lead to materially different RER dynamics.
Interpretation of RER–external balance link: Evidence that only ULC-deflated RERs align with expenditure-switching suggests caution when using CPI- or GDP-deflator-based RERs to infer contemporaneous expenditure-switching effects.

IMF Working Paper — "Real Exchange Rate and External Balance: How Important Are Price Deflators?"

Real Exchange Rate and External Balance: How Important Are Price Deflators?, WP/17/81, March 2017
- Real Exchange Rate and External Balance: How Important Are Price Deflators?, WP/17/81, March 2017 (Markdown version)
- Real Exchange Rate and External Balance: How Important Are Price Deflators?, WP/17/81, March 2017 (PDF)