Accounting for U.S. Real Exchange Rate Changes

This 1999 Journal of Political Economy paper (NBER Working Paper 5394, 1995) by Charles Engel asks how much of the historical variation in the U.S. real exchange rate against other high-income countries can be attributed to relative-price movements in non-traded goods – the channel most open-economy models of the real exchange rate emphasize – versus movements in the relative price of traded goods, which includes the nominal exchange rate itself. Decomposing the mean-squared error, variance, and drift of the real exchange rate at horizons from one month to thirty years, using five separate measures of traded/non-traded prices built from consumer prices, OECD sectoral output prices, national-accounts consumption deflators, producer price indexes, and (for Japan) disaggregated corporate-services prices, Engel finds that the traded-goods component accounts for essentially all of the movement in the U.S. real exchange rate at every horizon, for almost every country pair and sample period examined – the share attributed to non-traded goods stays close to zero even over multi-decade horizons where sticky-price theories predict non-traded prices should dominate. The pattern holds whether nominal exchange rates are floating (1973-1995) or fixed (1962-1970), and it survives an explicit check for whether the traded-goods price indexes themselves are contaminated by non-tradable marketing and distribution costs: Japanese data on thirty-six categories of corporate-service prices show no systematic rise relative to the CPI that could explain the yen’s real appreciation. Canada, and under one producer-price-based measure a handful of European countries, are partial exceptions where the non-traded component matters more at long horizons, but the paper cautions this particular decomposition is highly sensitive to an arbitrary assumption about how to split the covariance between the two components. Engel concludes that whatever drives the dominant traded-goods component – a composition/terms-of-trade explanation, he finds, contributes “very little” – deviations from the law of one price for individual traded goods, rather than the relative price of non-traded to traded goods, is the more promising place to look.

Monetary Policy in the Open Economy Revisited: Price Setting and Exchange-Rate Flexibility

This 2003 Review of Economic Studies paper by Michael Devereux and Charles Engel builds a welfare-based, two-country stochastic sticky-price model – extending Obstfeld and Rogoff (1995, 1998) – to ask how far monetary policy should be used to stabilize the exchange rate. The source text used here is the authors’ July 2000 Hong Kong Institute for Monetary Research working-paper draft, three years ahead of the final publication; the title and central results match the published version exactly (confirmed against the published abstract and against the paper’s own citation by Obstfeld and Rogoff 2000), so this is used as a legitimate, if textually earlier, source. The paper’s key move is to contrast two assumptions about the currency in which exporters preset prices: producer-currency pricing (PCP), the traditional Friedman/Mundell-Fleming assumption under which exchange-rate changes pass through fully to import prices, and local-currency pricing (LCP), in which exporters preset prices in the buyer’s currency so that exchange-rate changes have no short-run effect on either country’s import prices – an assumption the authors argue fits the empirical evidence on low observed pass-through much better. Under PCP, optimal monetary policy must use exchange-rate flexibility to replicate the flexible-price allocation in the face of country-specific productivity shocks, confirming the traditional Friedman case for floating rates; but because the model is solved exactly rather than linearized, exchange-rate volatility itself enters the welfare-based policy objective as an independent cost (by lowering expected, not just the variance of, consumption), so even a country with a perfectly stable money supply never finds a completely clean float optimal under PCP. Under LCP, by contrast, the exchange rate plays no role at all in the optimal response to productivity shocks – a constant exchange rate is optimal even facing purely country-specific real shocks, directly at odds with the Friedman/Mundell logic – and because exchange-rate volatility carries no independent welfare cost under LCP, a country with a sufficiently stable monetary sector should let its currency float completely to insulate domestic consumption from foreign monetary disturbances. Whether PCP or LCP delivers higher overall welfare is, in general, ambiguous, since LCP’s insulation from foreign monetary shocks trades off against PCP’s superior adjustment to productivity shocks.

Charles Engel | Macro Paper Warehouse

Accounting for U.S. Real Exchange Rate Changes

Monetary Policy in the Open Economy Revisited: Price Setting and Exchange-Rate Flexibility