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The Real Exchange Rate Always Floats

Explore the concept of real exchange rates and their behavior over time. The real exchange rate always floats as relative prices at home and abroad constantly change. Discover the reasons behind fluctuations in real exchange rates and how they impact trade flows. Gain insights into long-term trends and the effects of inflation on overvaluation. This comprehensive outline by Thorvaldur Gylfason sheds light on the intricate dynamics of exchange rates and trade. Learn about the NATREX model's trajectory and the classification of different cases. Dive into trigonometry to understand fluctuations and stability in real exchange rates. Empirical estimates and practical examples provide a deeper understanding of real exchange rate dynamics. Visit www.hi.is/~gylfason for more details.

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The Real Exchange Rate Always Floats

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  1. The Real Exchange Rate Always Floats Thorvaldur Gylfason

  2. 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

  3. Part I: They float 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 Relative prices adjust so as to equilibrate markets

  4. Two Definitions • Even if prices are not sticky, wages often are • Real exchange rate varies directly with inflation

  5. Inflation and Overvaluation Real exchange rate Suppose inflation is 10 percent per year 110 Average 105 100 Time

  6. Hence, increased inflation increases the real exchange rate as long as the nominal exchange rate adjusts with a lag Inflation and Overvaluation Real exchange rate Suppose inflation rises to 20 percent per year 120 110 Average 100 Time

  7. 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

  8. More on Japan • The yen is overvalued, or at least high • 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 Brings home the importance of looking at the real as well as monetary determinants of exchange rates

  9. 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

  10. Classification of Cases

  11. Classification of Cases

  12. Classification of Cases

  13. Classification of Cases

  14. Classification of Cases

  15. Part II: They fluctuate A Little Trigonometry Fluctuations! R = real exchange rate B = current account balance

  16. Real effective exchange rates 1990-1999 (1995 = 100)

  17. From Lags to Swings

  18. From Lags to Swings Oscillations Stability

  19. Empirical Estimates of Elasticities Lagged effects are smaller than concurrent effects

  20. The paper is on my website: www.hi.is/~gylfason In Conclusion • Real exchange ratesfloat … • 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 The End

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