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II Long-Run Movements in Real Exchange Rates II Long-Run Movements in Real Exchange Rates Peter Isard and Steven Symansky Economists have shown little ability to explain which observed changes in currency values are exchange rate movements from day to day, likely to persist. Accordingly, economists are contin- month to month, or even year to year. As revealed by uing to address a number of unresolved issues about several extensive studies undertaken in the early the nature of the long-run relationships between ex- 1980s, which focused on the currencies of major in- change rates and national price or cost levels. This dustrial countries, the most widely used structural section reviews these issues and summarizes exist- models of exchange rates could not outperform a ing attempts to shed light on them empirically. It naive random-walk model over horizons of twelve also examines empirical evidence from the APEC re- months or less, even in predicting the realized be- gion,4 which presents a wide range of economic ex- havior of exchange rates using the realized values of periences, including a number of economies in the "exogenous" explanatory variables (Meese and which real output has expanded rapidly, thus provid- Rogoff, 1983a and 1983b). Moreover, subsequent ing an attractive focus for a study of the long-run be- efforts to improve the structural models have havior of exchange rates. achieved very limited success in outperforming the random-walk model over short-term horizons.1 Much greater success has been achieved, how- Historical Perspectives ever, in explaining the behavior of exchange rates for the APEC Region over relatively long time intervals. More specifi- cally, nominal exchange rates and ratios of national The theories addressed in this section focus on the price or cost levels have been observed to change by behavior of nominal exchange rates relative to vari- similar orders of magnitude over long periods. This ous ratios of national price or cost levels. The ratio can be seen in Figure 2-1, for example, which plots of the domestic national price level (P) to the foreign for each APEC member the average annual percent- price level (P*), after multiplying by the nominal ex- age change in its nominal exchange rate against the change rate (S) to convert domestic prices into for- U.S. dollar over the period 1973-94 (vertical axis) eign currency units, is commonly referred to as the versus the average annual percentage change in the real exchange rate (Q): ratio of its GDP deflator to the U.S. GDP deflator Q = SP/P*. (2-1) (horizontal axis). The chart shows a strong correla- tion between changes in nominal exchange rates Widely used measures of real exchange rates include and changes in ratios of national price levels over those based on ratios of GDP deflators, consumer price indices, wholesale price indices, export price the past two decades. Although the average annual 5 changes have been approximately the same in many indices, and unit labor costs. cases,2 in some instances they have differed consid- Figure 2-2 shows time series of annual data on erably. Consistently, a growing literature has chal- four different real exchange rate measures for each of lenged the appropriateness of models that assume that nominal exchange rates and ratios of national 4 3 The extent to which the relevant theories can be tested empiri- price levels have identical trends over the long run. cally depends on whether the available data on employment and Models of the long-run behavior of exchange rates capital stocks are adequate for constructing quantitative measures of labor productivity or total factor productivity in the tradables are particularly relevant for assessing the extent to and nontradables sectors. For most APEC members such data are inadequate. Nevertheless, other data available for APEC members are sufficient to illustrate a number of relevant points about the 1See the recent surveys by Frankel and Rose (forthcoming), long-run behavior of exchange rates. Isard (1995), and Taylor (1995a, 1995b). 5See Clark and others (1994), Marsh and Tokarick (1994), and 2Figure 2-1 includes a 45-degree line for comparison. Turner and Van't dack (1993) for recent theoretical and empirical 3See Boucher Breuer (1994), Froot and Rogoff (forthcoming), assessments of how well the different measures of real exchange and Rogoff (1996) for reviews of the relevant literature. rates capture international price and cost competitiveness. 7 ©International Monetary Fund. Not for Redistribution II LONG-RUN MOVEMENTS IN REAL EXCHANGE RATES shows corresponding time series of multilateral real Figure 2-1. Nominal Exchange Rates exchange rates based on national-source GDP defla- and Ratios of GDP Deflators1 tors, along with the associated bilateral rates vis-a- (Average annual percent change, 1973-94) vis both Japan and the United States. Figure 2-2 reveals that, for most APEC members, the different measures of real exchange rates have diverged significantly over certain periods while also exhibiting fairly similar cyclical behavior.9 The dis- cussion of the empirical evidence and the conclu- sions suggested by the analysis (below) focus on the relevance of both the cyclical similarities and the differences in long-run trends. Figure 2-3 shows that in virtually all cases the overall changes in multi- lateral rates have been somewhere in between the overall changes in bilateral rates against the dollar and against the yen; this reflects the importance to APEC members of trade with both Japan and the United States, together with the overall appreciation of the yen against the dollar. Figures 2-2 and 2-3 also reveal striking contrasts in exchange rate trends among different APEC members. With regard to the real exchange rates based on GDP deflators, con- Ratio of national price levels sumer price indices, and Penn price relatives, Japan, 1 Korea, and Taiwan Province of China have experi- Nominal exchange rates are measured in U.S. dollars per unit of local currency.The ratio of price levels is the U.S. GDP deflator enced substantial real appreciations vis-a-vis the divided by the domestic GDP deflator. Annual averages are based United States since 1973; several other APEC mem- on the data available within the 1973-94 period. For Chile and Mexico, not shown, the horizontal and vertical coordinates are bers have experienced small-to-moderate deprecia- (-21.3, -21.7) and (-24.6, -23.8), respectively. tions; and China and Indonesia have had substantial depreciations. In analyses of long-run trends in real exchange rates among the industrial countries, the real appre- 6 ciation of the yen over the past two decades is the APEC members vis-a-vis the United States. generally associated with the relatively rapid ex- Three of the real exchange rate measures—in partic- pansion of output in Japan. As the analysis in this ular, those based on GDP deflators, consumer price section shows, however, data for the APEC region indices, and export price indices—are constructed as suggest that the long-run relationship between the nominal exchange rate (in U.S. dollars per unit of output growth and real exchange rate appreciation domestic currency) multiplied by the relevant domes- is not robust. In particular, there are several mem- tic price level divided by the corresponding U.S. 7 bers of APEC in which output growth since 1973 price level. By contrast, the real exchange rates has been significantly more rapid than in Japan, based on Penn price relatives are constructed from while real exchange rates (vis-a-vis the United estimates of the relative domestic and U.S. prices for States) have not appreciated. Some reasons why individual product categories, without using data on rapid output growth has not always been accompa- nominal exchange rates (a detailed description is pro- 8 nied by real exchange rate appreciation are ad- vided in the discussion of empirical evidence, below). The graphs in Figure 2-2 start in 1960 but in some cases are limited by data availability. Figure 2-3 9Some of the divergence between the different real exchange rate measures might be attributable to problems of data quality. 6There is no chart for the United States because all variables Accordingly, as a crude way of identifying data series that might are measured relative to the U.S. dollar, or for Brunei Darus- be suspect, we looked for contrasts among four real exchange rate salam, whose currency notes are exchangeable at par with those measures: the real exchange rate based on GDP deflators, the of Singapore. Penn measure constructed with GDP weights, the real exchange 7The time series on these three measures, based on data from rate based on consumer price indices, and an alternative Penn national sources, are from the IMF's International Financial Sta- measure constructed with weights that reflect consumption tistics and World Economic Outlook databases. shares. Except in the cases of Indonesia and Korea, the four mea- 8Data on the Penn measures, in which price relatives (domestic sures appear to be reasonably consistent. For Indonesia, the real versus United States) for individual products are aggregated with exchange rate based on national-source GDP deflators is a clear weights that reflect shares in domestic real GDP, are from the outlier, while for Korea the measure based on national-source Penn World Table; see Summers and Heston (1991). consumer price indices is the outlier. 8 ©International Monetary Fund. Not for Redistribution Historical Perspectives for the APEC Region Figure 2-2. Real Exchange Rates vis-a-vis the United States (1973 = 100) 9 ©International Monetary Fund. Not for Redistribution II LONG-RUN MOVEMENTS IN REAL EXCHANGE RATES Figure 2-2 (concluded) 10 ©International Monetary Fund. Not for Redistribution Historical Perspectives for the APEC Region Figure 2-3.
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