Real Exchange Rate Dynamics Beyond Business Cycles
61 Pages Posted: 15 Apr 2020
Date Written: March 10, 2020
We examine how medium-term movements in real exchange rates and GDP vary with international financial conditions. For this purpose, we study the international transmission of productivity shocks across a variety of IRBC models that incorporate different assumptions about the persistence of productivity shocks, the degree of international risk sharing and access to international asset markets. Using a new global solution method, we demonstrate that the transmission of productivity shocks depends critically on the proximity of a national economy to its international borrowing limit. We then show that this implication of the IRBC model is consistent with the behavior of the US-UK real exchange rate and GDP over the past 200 years. The model also produces a negative correlation between relative consumption growth and real depreciation rate consistent with more recent data, and hence offers a resolution of the Backus-Smith puzzle.
Keywords: Real Exchange Rates, International Real Business Cycles, Banking Crises, Backus-Smith Puzzle, Incomplete Markets, Global Solution Methods
JEL Classification: C60, F30, F31, F41, F44, G11
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