The Real Exchange Rate

International Macroeconomics

Philippe Bacchetta
HEC Lausanne

January 2012

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Introduction

The real exchange rate is the relative price of domestic vs foreign

goods
Typically measured as:
Pt
Qt = St
Pt
St : nominal exchange rate
Pt , Pt : domestic and foreign price levels
Qt ": real depreciation, domestic goods relatively cheaper
However in practice often show 1/Qt
Empirical evidence shows that the real ER
varies widely
is related to CA movements

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Real exchange rate volatility

Why does the real exchange rate vary so much?

The law of one price says that goods should cost the same across
borders
Purchasing Power Parity (PPP) says that Pt = St Pt so that Qt is
constant
But widespread evidence againts PPP
One way to explain ‡uctuations in Qt is to assume that prices are rigid
Then ‡uctuations in Qt come from ‡uctuations in St . Consider this
later
If prices are relatively ‡exible (e.g. in the medium run), need to
explain ‡uctuations in Qt

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Explaining ‡uctuations in the real exchange rate

Since Qt is a relative price, there must be di¤erences between

domestic and foreign goods
One way is to distinguish between traded and non-traded goods (or
tradeable vs non-tradeable)
When goods are traded, easier to arbitrage =) deviations from
arbitrage most likely to come from non-traded goods
Many goods are non traded, e.g. services
The proportion of non-traded goods is large: typical estimates are
40-60%
But some say it is much higher because of distribution sector
Even traded goods have an element non traded (e.g. Big Mac)

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Traded and non-traded goods prices

Let PtN and PtT be the non-traded and traded goods prices
Let α be the share of non-traded goods
We can assume
α 1 α
Pt = PtN PtT

so that:
Pt
Qt = St α 1 α
PtN PtT
Assume the price of foreign goods is given =) St Pt is given
Then it is the relative price PtN /PtT that determines Qt

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 De…ne by pt this relative price: pt = PtN /PtT
Assume St Pt = 1 and normalize PtT = 1. Then Qt = pt α

pt ": real apprecation

Real models of the real ER explain ‡uctuations in pt
We will do this in the two-period model and see the link with CA

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A two-period model with non-traded goods

Consider a benchmark intertemporal model with traded and

non-traded goods
Output is given: YtT , YtN
Consumption: CtT , CtN
Utility in a period: U (CtT , CtN )
U strictly increasing and concave
Several interesting things can happen depending on the cross
derivative UC T C N

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 When UC T C N < 0, the goods are substitutes
increase C N =) UC T # =) tend to consume less of C T
When UC T C N > 0, the goods are complements
C T and C N tend to move in the same direction
When UC T C N = 0, the goods are independent
We will focus on the latter case

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Budget constraint and optimization

We typically express variables in terms of traded goods

In general the budget constraint is:

Bt + 1 Bt = rBt + YtT + pt YtN CtT pt CtN

Consider periods 1 and 2:

C1T + p1 C1N = Y1T + p1 Y1N B2

C2T + p2 C2N = Y2T + p2 Y2N + (1 + r )B2

Intertemporal budget constraint:

C2T + p2 C2N
C1T + p1 C1N + =W
1+r

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 Utility:
Max U (C1T , C1N ) + βU (C2T , C2N )
C 1T ,C 1N ,C 2T ,C 2N

Maximize Lagrangian with intertemporal budget constraint, with λ

Lagrange multiplier

UC T
1
= λ UC N = p 1 λ
1
λ λ
βUC T = βUC N = p2
2 1+r 2 1+r
Assume β(1 + r ) = 1
Then:
UC T = U C T = λ
1 2

If CtT and CtN are independent, C1T = C2T

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 For the non-traded good we have:

UC N = p 1 λ UC N = p 2 λ
1 2

In general C1N and C2N not equal (unless p1 = p2 )

In equilibrium
C1N = Y1N C2N = Y2N
Therefore:

B2 = Y1T C1T
(1 + r )B2 = Y2T C2T

Not surprisingly, CA depends only on di¤erence in traded goods

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Determining the real ER

From the FOC we have:

UC N UC N
1 2
p1 = p2 =
UC T UC T
1 2

Depends on speci…c utility function

Assume:
U (C1T , C1N ) = ln C1T + ln C1N
Then:
C1T C1T C2T C2T
p1 = = p2 = =
C1N Y1N C2N Y2N

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Link between real ER and CA

Consider the impact of shocks

1. Permanent increase in Y N

C1N ", C2N "

What about C1T , C2T ? Intertemporal budget constraint (in
equilibrium):
CT YT
C1T + 2 = Y1T + 2
1+r 1+r
No change. Thus, p1 #, p2 #: permanent real depreciation
Richer due to increase in Y N , but real depreciation =) traded goods
are more expensive =)no change in C1T , C2T
No change in CA, while real depreciation

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2. Permanent increase in Y N , Y T

no change in p
Both C N ", C T "
No impact on CA
Typically need a temporary shock to get an impact on the CA

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3. Temporary increase in Y N , Y T

Keep Y N /Y T constant
We still have C1T = C2T , but higher C1T
C1T increases less than Y1T
On the other hand, C1N increases the same as Y1N
C 1T
Hence C 1N
# so that p1 #: real depreciation
Supply e¤ect on the real ER: a higher growth may imply a real
depreciation

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 For the current accout, one can derive (since C1T = C2T ):

Y1T Y2T
B2 =
2+r
CA surplus with currency depreciation
Inversely, with negative shock we would have CA de…cit with
appreciation
"Standard" link between CA and RER, but no causality
Intuition: Y1T , Y1N " implies excess supply of domestic goods. The
price decreases and the surplus is sold on world markets
Negative shocks to demand of domestic goods would have a similar
e¤ect

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 Main messages:
no systematic link between CA and RER
When there is a correlation, there is not necessarily causality
Depends on the shocks
The benchmark two-period model gives useful insights. But is too
simplistic to explain real world phenomena
Various extensions are needed
We will still see an application based a set of papers by Obstfeld and
Rogo¤

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How far should the dollar fall?

How large a depreciation to correct the US CA balance?

In equilibrium:
CA1 = Y1T C1T
Let Y1 be total output: Y1 = Y1T + p1 Y1N
We had:
CA1
' 6%
Y1
Assume C1T /Y1 = 25%
Assume Y1 constant =) adjustment has to come from C1T
Assume the objective is to bring CA to zero =) reduce CA1 /Y1 by
6%

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 Therefore:
∆C1T
= 6%
Y1
We have:
∆C1T C1T ∆C1T C1T
=
Y1 C T C1T |{z}
Y1
| {z 1 }
6% 25%

so that:
∆C1T 6%
= = 24%
C1T 25%
24% reduction in consumption of traded goods

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 Real exchange rate with log preferences:
C1T
p1 =
Y1N
If Y1N is constant, need:
∆p1
= 24%
p1
24% real depreciation
This number depends on the utility function and the subtitutability
between CtT and CtN
Another question is how much the nominal exchange rate should
depreciate to have such a real depreciation
Obstfeld&Rogo¤ estimated a nominal depreciation of about 50%
This approach does not deal with the sources of the CA de…cit and
does not consider the dynamics
But some other researchers reach similar conclusions in a dynamic
setup
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Introducing production

Abstract from capital and assume:

YtT = F T (LTt )
YtN = F N (LNt )

It is often assumed that the total amount of labor is constant:

L = LTt + LN
t

Let wt be the wage measured in terms of traded goods

Firms’pro…ts are (abstracting from time subscript):

πT = Y T wLT
πN = pY N wLN

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 Pro…t maximization gives:

F T 0 ( LT )
p=
F N 0 ( LN )

This should be combined with the optimal condition for consumption:

UC N
p=
UC T

which gives:
F T 0 ( LT ) U N
N 0 N
= C
F (L ) UC T
Solve for LT , LN , C N , and C T using budget constraint, labor market
constraint, and non-traded goods equilibrium
Graphical analysis with production possibility frontier and indi¤erence
curves
Both productivity and taste matter for the real exchange rate
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Special case

Assume linear production function

YT = a T LT
YN = a N LN

Real exchange rate depends only on technology:

aT
p=
aN
Real exchange rate depends on relative productivities:
Balassa-Samuelson model
Countries with higher productivity in traded goods (rich countries)
have a higher p and a higher price

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Terms of trade (tot)

price exports/price imports

In the model = 1
But in general not the case. Changes in tot would a¤ect real
exchange rate
Can be modeled by assuming Home-produced goods, Y H , and
Foreign-produced goods, Y F
Their relative price determines tot
Possible to add non-traded goods. The real exchange rate would then
be determined both by tot and by P N /P T

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