Real Exchange Rate Fluctuations and the Business Cycle: Evidence From Japan

IMF Working Papers, November 1, 1996

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Paper analyzes the relationship between the real exchange rate and the business cycle in Japan during the floating rate period.
Uses a structural vector autoregression to identify different types of macroeconomic shocks that determine fluctuations in aggregate output and the real exchange rate.
Summary finding: relative nominal and real demand shocks are the main determinants of variation in real exchange rate changes, while relative output growth is driven primarily by supply shocks.
Historical decompositions indicate that the sharp appreciations of the yen in 1993 and 1995 and its subsequent depreciation can be attributed primarily to relative nominal shocks.

Empirical approach: structural vector autoregression (SVAR) to identify macroeconomic shocks affecting aggregate output and the real exchange rate.
Focus: disentangling relative nominal shocks, relative real demand shocks, and supply shocks in driving exchange rate and output fluctuations.

Determinants of real exchange rate changes:
- Relative nominal shocks: main determinant.
- Relative real demand shocks: also a primary determinant.
Determinants of relative output growth:
- Supply shocks: primary driver.
Historical episodes:
- Sharp appreciations of the yen in 1993 and 1995 and the subsequent depreciation are attributed primarily to relative nominal shocks.

Exchange rate volatility during the floating rate period is closely linked to nominal and demand-side shocks, suggesting policy attention to nominal stability and demand management to mitigate real exchange rate swings.
Output dynamics are largely supply-driven, highlighting the role of supply-side policies in stabilizing relative output growth.