Real exchange rate: Empirical Challenges
Despite much work, little is known about the empirical determinants of real exchange rates. A large number of econometric studies have attempted to determine whether the exchange rate converges over time to an equilibrium value that is, whether it is stationary. The focus on this particular issue arises in large part because it is equivalent to knowing whether relative purchasing power holds, in which case nominal exchange rate changes and inflation differences eventually offset each other. The persistence of real exchange rate changes, however,means that tests even of this fairly clear-cut hypothesis lack statistical power, even with long time series or with panel data.
Econometric work that attemptsmore broadly to discern the real exchange rate’s most important determinants and thereby to distinguish among competing theories has had only limited success. The real exchange rate’s volatility and persistence are not matched by observations of its theoretical fundamentals, and it is difficult to generate endogenous persistence in real exchange rate models without introducing other counterfactual implications.
Thus empirical studies have been able to tell us only a few things. First, real exchange rates tend to move with nominal exchange rates, and their behavior correspondingly depends on prevailing nominal exchange rate arrangements. Second, real exchange rates are volatile. Finally, their changes are persistent. Even this last conclusion is subject to the criticism that it may be an artifact of poor measurement.