Real exchange rate: Theoretical Approaches
Most theoretical approaches to understanding real exchange rates focus on the price of goods. These explanations generally fall into two categories.The first category emphasizes the importance of international borders, particularly those aspects of borders that prevent the law of one price from holding internationally. The second category emphasizes what goes on within countries, especially what happens to the relative prices of traded and nontraded goods within an individual country. International failures in the lawof one price and international differences in relative prices within countries are related, but they each capture different ideas of what is important in determining real exchange rates.
Across international borders, the law of one price fails for many goods, and its failure is particularly notable for final goods. Its failure can occur most obviously because of transportation costs and official trade barriers, but it also can occur because of noncompetitive market structures, in which prices resist change. Inmanynewopeneconomymacroeconomic models, firms have monopoly power and prices are set as a markup over marginal cost. In these models, the law of one price can fail, at least in the short term. Failures of the law of one price represent impediments to the adjustment of the real exchange rate.
Looking within countries, explanations of real exchange rate behavior emphasize distinctions between different sectors of the economy, such as the traded and nontraded sectors, or the intermediate and final sectors. These explanations tend to rely either on differential changes in productivity across the sectors or on changes in the relative demands across the sectors. All such changes affect the relative prices and the composition of what is produced and consumed in each country. Such changes, in turn, affect the real exchange rate via the price indicators that we see in its definition. The most prominent of these explanations is the Balassa-Samuelson effect.
The other explanations of real exchange rate behavior are primarily shorter-term explanations. Changes in preferences across an economy’s traded and nontraded sectors whether due to changes in consumption or government expenditures will affect relative prices for as long as it takes for the factors of production to move across the sectors within a country. (Some of the new open economy models fit into this category aswell.) In the short run, the supply of nontraded goods is inelastic, and the demand for nontraded goods matters. So changes in the consumption of nontraded goods will affect relative prices, and real exchange rates will change.