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Real Exchange Rate and External Balance: How Important Are Price Deflators?
Author(s) -
AHN JAEBIN,
MANO RUI C.,
ZHOU JING
Publication year - 2020
Publication title -
journal of money, credit and banking
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.763
H-Index - 108
eISSN - 1538-4616
pISSN - 0022-2879
DOI - 10.1111/jmcb.12746
Subject(s) - gdp deflator , economics , effective exchange rate , price index , index (typography) , exchange rate , real gross domestic product , econometrics , monetary economics , unit (ring theory) , balance (ability) , relative price , mathematics , computer science , medicine , mathematics education , world wide web , physical medicine and rehabilitation
This paper contrasts real effective exchange rate (REER) measures based on different deflators (consumer price index, GDP deflator, and unit labor cost) and discusses potential implications for the link—or lack thereof—between the REER and the external balance. We begin by comparing the evolution of different measures of REER to confirm that the choice of deflator plays a significant role in REER movements. A subsequent empirical investigation based on 35 developed and emerging market economies over 1995–2017 yields comprehensive and robust evidence that only the REER deflated by unit labor cost exhibits contemporaneous patterns consistent with the expenditure‐switching mechanism. Finally, we show that a standard open‐economy model with nominal rigidities and trade in intermediate goods is able to generate these aforementioned patterns.