1. The Real Exchange Rate Always Floats Thorvaldur Gylfason

2. Outline  Make two points about long-run behavior of real exchange rates  They float  They float, always  because relative prices at home and abroad move about  They fluctuate  because it takes time for the effects of real exchange rate changes on trade flows to materialize in full

3. But First This relative price The exchange rate is a relative price But relative price of what? Domestic and foreign moneys? nominal Yes, the nominal exchange rate is a monetary phenomenon, but exchange rate regimes are not, they are “real” Exchange rate regimes have real effects Domestic and foreign GDP? real Yes, the real exchange rate is, of course, a real phenomenon Relative prices adjust so as to equilibrate markets Part I: They float

4. Two Definitions  Even if prices are not sticky, wages often are  Real exchange rate varies directly with inflation

5. Inflation Inflation and Overvaluation Time Real exchange rate 100 110 105 Average Suppose inflation is 10 percent per year

6. Inflation and Overvaluation Time 100 120 Real exchange rate 110Average Hence, increased inflation increases the real exchange rate as long as the nominal exchange rate adjusts with a lag Suppose inflation rises to 20 percent per year

7. Two Types of Overvaluation  African type government intervention high inflation  Real exchange rates kept artificially high by government intervention as well as by high inflation  Should Africa fix of flex?  Japanese type domestic inefficiency  Real exchange rates kept high primarily by domestic inefficiency

8. Japan More on Japan The yen is overvalued, or at least high  How do we see this?  Not by looking at Japan´s monetary or balance of payments statistics  No, Japan’s per capita GDP seems overvalued at the current exchange rate of the yen  Japan’s PPP-adjusted per capita GDP is far lower and more accurate real determinants Brings home the importance of looking at the real as well as monetary determinants of exchange rates

9. Language A Remark on Language In some languages, the word for “exchange rate” is loaded exchange rate success In Icelandic, at any rate, the word for “exchange rate” is synonymous with success A high exchange rate means a high per capita GDP measured in foreign currency Governments, therefore, have a vested interest in overvaluation overvaluation tends to reduce long- run growth The short-run temptation to keep income high though overvaluation depresses trade, hurts stability, and thus tends to reduce long- run growth

10. NATREX Model: Some Results NATREX is a trajectory, not a number Solve e t MT from CA t = S t – I t Two main results:  Increased productivity  Increased productivity leads to real appreciation  Increased expenditure  Increased expenditure (“social consumption”) leads to real depreciation

11. Classification Classification of Cases High productivity Low productivity High consumption Low consumption

12. Classification Classification of Cases High productivity Low productivity High consumption Weak currency, low income: Africa Low consumption

13. Classification Classification of Cases High productivity Low productivity High consumption Weak currency, low income: Africa Low consumption Strong currency, high income: Hong Kong

14. Classification Classification of Cases High productivity Low productivity High consumption Weak currency, low income: Africa Low consumption Strong currency, high income: Hong Kong Japan (?)

15. Classification Classification of Cases High productivity Low productivity High consumption United States, European Union Weak currency, low income: Africa Low consumption Strong currency, high income: Hong Kong Japan (?)

16. A Little Trigonometry Fluctuations! R = real exchange rate B = current account balance Part II: They fluctuate

17. Real effective exchange rates 1990-1999 (1995 = 100)

18. From Lags to Swings

19. Swings From Lags to Swings Oscillations Stability

20. Empirical Estimates of Elasticities Export elasticity Import elasticity Industrial countries 1.110.99 Developing countries 1.11.5 Lagged effects are smaller than concurrent effects

21. In Conclusion The End The paper is on my website: www.hi.is/~gylfason  Real exchange ratesfloat …  Real exchange rates float … dominated by movements in the nominal exchange rate  The real exchange rate of the Euro is dominated by movements in the nominal exchange rate, not in relative prices  More often, real exchange rate movements are dominated by price changes, as in Hong Kong  … and fluctuate as well  due to dynamic interaction between real exchange rates and trade flows