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The Real Exchange Rate Always Floats Thorvaldur Gylfason Outline Make two points about long-run behavior of real exchange rates They float, always because relative prices at home and abroad move about They fluctuate because it takes time for the effects of real exchange rate changes on trade flows to materialize in full But First This The exchange rate is a relative price But relative price of what? Domestic and foreign moneys? Yes, the nominal exchange rate is a monetary phenomenon, but exchange rate regimes are not, they are “real” Exchange rate regimes have real effects Domestic and foreign GDP? Yes, the real exchange rate is, of course, a real phenomenon Two Definitions eW eP Rw Rp W* P* Even if prices are not sticky, wages often are Real exchange rate varies directly with inflation Inflation and Overvaluation Real exchange rate Suppose inflation is 10 percent per year 110 105 100 Average Time Inflation and Overvaluation Real exchange rate Suppose inflation rises to 20 percent per year 120 110 Average 100 Time Two Types of Overvaluation African type Real exchange rates kept artificially high by government intervention as well as by high inflation Should Africa fix of flex? Japanese type Real exchange rates kept high primarily by domestic inefficiency More on Japan The yen is overvalued, or at least high Brings home the importance of looking at the real as well as monetary determinants of exchange rates How do we see this? Not by looking at Japan´s monetary or balance of payments statistics No, Japan’s per capita GDP seems overvalued at the current exchange rate of the yen Japan’s PPP-adjusted per capita GDP is far lower and more accurate NATREX Model: Some Results NATREX is a trajectory, not a number Solve etMT from CAt = St – It Two main results: Increased productivity leads to real appreciation Increased expenditure (“social consumption”) leads to real depreciation Classification of Cases High productivity High consumption Low consumption Low productivity Classification of Cases High productivity High consumption Low consumption Low productivity Weak currency, low income: Africa Classification of Cases High productivity High consumption Low consumption Low productivity Weak currency, low income: Africa Strong currency, high income: Hong Kong Classification of Cases High productivity High consumption Low consumption Low productivity Weak currency, low income: Africa Strong currency, Japan (?) high income: Hong Kong Classification of Cases High productivity Low productivity High consumption United States, European Union Weak currency, low income: Africa Low consumption Strong currency, Japan (?) high income: Hong Kong A Little Trigonometry dR B dt dB R dt R = real exchange rate B = current account balance B(t ) cos(t ) R (t ) sin( t ) Real effective exchange rates 1990-1999 (1995 = 100) 130 120 110 100 90 80 70 Australia Japan Philippines China New Zealand Africa 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 60 From Lags to Swings X t a0Y e e *a1 a2 a3 t t t 1 b1 b2 b3 t t t 1 M t b0 Y e e Bt X t et M t 0 a3 b3 ln( et ) ln( et 1 ) c a2 b2 1 From Lags to Swings a2 b2 1 a2 b2 1 a3 b3 Oscillations Stability a3 b3 ln( et ) ln( et 1 ) c a2 b2 1 Empirical Estimates of Elasticities a2 b2 1 Export elasticity Industrial countries Developing countries Lagged effects are smaller than concurrent effects Import elasticity 1.11 0.99 1.1 1.5 a2 b2 1 a3 b3 The paper is on my website: www.hi.is/~gylfason In Conclusion Real exchange rates float … The real exchange rate of the Euro is dominated by movements in the nominal exchange rate, not in relative prices More often, real exchange rate movements are dominated by price changes, as in Hong Kong … and fluctuate as well due to dynamic interaction between real exchange rates and trade flows