Real Exchange Rate and External Balance: How Important are Price Deflators?

50 Pages Posted: 12 May 2017

See all articles by JaeBin Ahn

JaeBin Ahn

International Monetary Fund (IMF)

Rui C. Mano

International Monetary Fund

Jing Zhou

Columbia University

Date Written: March 2017

Abstract

This paper contrasts real exchange rate (RER) measures based on different deflators (CPI, GDP deflator, and ULC) and discusses potential implications for the link-or lack thereof-between RER and external balance. We begin by documenting patterns in the evolution of different measures of RERs, and confirm that the choice of deflator plays a significant role in RER movements. A subsequent empirical investigation based on 35 developed and emerging market economies over 1995 to 2014 yields comprehensive and robust evidence that only the RER deflated by ULC exhibits contemporaneous patterns consistent with the expenditure-switching mechanism. We rationalize the empirical findings by introducing a simple model featuring nominal rigidity and trade in intermediate goods as the one in Obstfeld (2001) and Devereux and Engel (2007), which is shown to generate qualitatively identical patterns to empirical findings.

Keywords: Foreign exchange, Real exchange rate; External balance; Expenditure switching; Deflators, Real exchange rate, External balance, Expenditure switching, Deflators, Open Economy Macroeconomics

JEL Classification: F31, F32, F41

Suggested Citation

Ahn, JaeBin and Mano, Rui C. and Zhou, Jing, Real Exchange Rate and External Balance: How Important are Price Deflators? (March 2017). IMF Working Paper No. 17/81. Available at SSRN: https://ssrn.com/abstract=2967436

JaeBin Ahn (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Rui C. Mano

International Monetary Fund ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

HOME PAGE: http://sites.google.com/site/ruimano/

Jing Zhou

Columbia University ( email )

3022 Broadway
New York, NY 10027
United States

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