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The Neo-classical theory of exchange rate determination, with a stock view of capital movements, has the equilibrium exchange rate dependent on purchasing power parity (PPP); that is, the bilateral nominal exchange rate is determined by the ratio of domestic to foreign price levels. Thus the real exchange rate is predicted to be constant. This prediction, however, is largely rejected by the data (see, for example Rogoff, 1996). Less restrictive models of the equilibrium exchange rate, such as the traditional Mundell-Fleming model (Mundell, 1963) or generalised portfolio balance (Branson and Buiter, 1983), assume that output is not fixed at the level of full employment, and postulate that the current account balance determines the equilibrium exchange rate. In other words, the real exchange rate, rather than assumed to be constant, is related to the relative output levels. The empirical implication of this hypothesis is that the real exchange rate should be co-integrated with the relative levels of domestic and foreign output. This hypothesis is, however, rejected by the data in this paper, just as the PPP relationship has been empirically rejected. This result notwithstanding, the real exchange rate does shown a long, cyclical pattern, not dissimilar to a business cycle pattern. Cyclical output patterns could translate into real exchange rate cycles, since the international transmission of the business cycle traditionally takes place through the trade balance (see, for example, Williamson and Milner, 1991). This cycle, however, is not apparent from either monthly or quarterly data because, as noted by Baxter (1994) in a different context, the frequency is too high. At lower frequencies, however, a cyclical relationship may emerge between output and the real exchange rate. If confirmed, this analysis also explains why PPP is rejected in the short to medium term, since it implies that the real exchange rate, rather than remain constant as suggested by PPP, in fact fluctuates over the business cycle.
This paper forms part of the ESRC funded project (Award No.
L1382511013) “Business Cycle Volatility and Economic Growth: A
Comparative Time Series Study”, which itself is part of the Understanding
the Evolving Macroeconomy Research programme.