Can International Macroeconomic Models Explain Low-Frequency Movements of Real Exchange Rates?
IMF Working Papers, January 1, 2012
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Bibliographic details
- Authors: Pau Rabanal, Juan F. Rubio-Ramirez
- Published: January 1, 2012
- Series: IMF Working Papers
Executive summary
- Real exchange rates exhibit important low-frequency fluctuations.
- Analyzing real exchange rates at all frequencies is more sound than the typical business cycle approach that compares actual and simulated data after the Hodrick-Prescott filter is applied to both.
- A simple two-country, two-good model (as described in Heathcote and Perri (2002)) can explain the volatility of the real exchange rate when all frequencies are studied.
- The model generates too much persistence of the real exchange rate instead of too little, contrary to business cycle analysis findings.
- Introducing adjustment costs in production and in portfolio holdings reconciles theory with this feature of the data.
Key findings and results
- Low-frequency fluctuations in real exchange rates are quantitatively important and should be included in empirical evaluation.
- Volatility explanation:
- The two-country, two-good model can match observed real exchange rate volatility when the full frequency spectrum is considered.
- Persistence puzzle:
- The model implies excessive persistence of the real exchange rate relative to the data pattern emphasized by business cycle filtered comparisons.
- Reconciliation mechanism:
- Adjustment costs in production and in portfolio holdings reduce the model’s excessive persistence and align theoretical dynamics with observed low-frequency behavior.
Methodological notes
- Critique of common practice:
- The paper argues that applying the Hodrick-Prescott filter to both actual and simulated data (the typical business cycle exercise) is inferior to studying real exchange rates across all frequencies.
- Model used:
- A simple two-country, two-good international macroeconomic model based on Heathcote and Perri (2002) is the core theoretical framework.
Subjects and keywords (as listed)
- Subjects: Consumption, National accounts, Production, Production growth, Total factor productivity
- Keywords: adjustment cost, Cointegration, Consumption, cost function, International Business Cycles, Production growth, Real Exchange Rates, RER fluctuation, RER spectrum, RER volatility, Spectrum, standard deviation, Total factor productivity, U.S. dollar, U.S. dollar RER, WP