Real Exchange Rate Dynamics Beyond Business Cycles

Abstract

We examine the determinants of medium-term movements in real exchange rates. Using US-UK data over the past 200 years, we find that the real exchange rate co-moves with GDP and the co-movements are significantly affected by banking crises. This relationship can be rationalized by an extension of the IRBC model with persistent productivity shocks and incomplete 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. The mechanism differs from the Harrod-Balassa-Samuelson effect which does not generate these state dependent responses.

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