A puzzle in international macroeconomics is that observed real exchange rates are highly volatile. Standard international real business cycle (IRBC) models cannot reproduce this fact. We show that total factor productivity processes for the United States and the rest of the world are characterized by a vector error correction model (VECM) and that adding cointegrated technology shocks to the standard IRBC model helps explaining the observed high real exchange rate volatility. Also, we show that the observed increase of the real exchange rate volatility with respect to output in the past twenty years can be explained by changes in the parameter of the VECM.
JEL classification: E32, F32, F33, F41
Key words: international business cycles, real exchange rates, cointegration
The authors thank Larry Christiano, Martin Eichenbaum, Jesús Gonzalo, Jim Nason, Fabrizio Perri, Gabriel Rodríguez, and Barbara Rossi for very useful comments. They acknowledge National Science Foundation support. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the author's responsibility.
Please address questions regarding content to Pau Rabanal, Research Department, International Monetary Fund, 700 19th Street, N.W., Washington, DC 20431, prabanal@imf.org; Juan F. Rubio-Ramirez (contact author), Duke University and Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, GA 30309-4470, 404 498 8708, juan.rubio-ramirez@duke.edu; or Vicente Tuesta, CENTRUM Católica and Central Reserve Bank of Peru, Jr. Antonio Miró Quesada 441-445, Lima-1, Perú, vicente.tuesta@bcrp.gob.pe.
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