What Determines Real Exchange Rate Fluctuations?

The real exchange rate (RER) is one of the most important price variables in macroeconomics as changes in it have implications for both external competitiveness as well as internal sectoral resource allocation. Accordingly, a great deal of attention has been paid to the causes of real exchange rate volatility. Broadly, there are four sets of literature in this area. The first focusses on linking RER volatility to the exchange rate regime and, in particular, the rise in volatility as a country shifts from fixed to flexible regimes — so-called “Mussa puzzle” (Stockman, 1983; Mussa, 1986). The second set of literature employs Vector Auto Regression (VAR) methods and variance decomposition techniques to estimate the relative contributions of real and nominal shocks to RER fluctuations (for example, see Clarida and Gali, 1994; Enders and Lee, 1997; Lastrapes, 1992; and Rogers, 1999). The third deals with the fundamental determinants of the long-run equilibrium RER (such as productivity, government spending, net foreign asset position, etc.) (for instance, see MacDonald, 2000; Ricci et al., 2008). A closely related literature attempts to determine the drivers of long-run deviations from purchasing power parity (PPP) and focusses on the reasons behind the well-known “PPP puzzle” Froot and Rogoff (1995) and Rogoff (1996) offer authoritative surveys. This literature also recognises the time-varying nature of the long-run RER which could evolve over time based on a set of economic and financial fundamentals.