RDP 8711: Deviations from Purchasing Power Parity: The Australian Case 6. Concluding remarks

This paper has sought to examine three questions:

• is the general downward trend of the real exchange rate with persistent deviations from that trend, consistent with the hypothesis of random deviations from PPP – with no tendency to revert to a constant equilibrium level?
• does the inclusion of commodity prices matter? For small economies specialised in commodity trade there may be a tendency for the equilibrium real exchange rate to change in response to shifts in the terms of trade; and
• since relative prices are more “sticky” (with smooth longer-run behaviour) than exchange rates, does the issue of managed versus floating rates bear on the question of whether deviations from PPP display random behaviour?

When the real exchange rate is analysed independently of commodity price developments, it is difficult to reject the hypothesis that deviations from PPP follow a random process. However, when information about the terms of trade is also included in the analysis, this conclusion is modified. In particular, it depends on the particular exchange rate regime in operation. This can be interpreted as evidence that deviations from PPP may arise as the predictable equilibrium response to changes in relative commodity prices. The particular cases for which this is true are also of interest in providing evidence on whether appropriate real exchange rate adjustment is best facilitated under managed or floating exchange rate regimes.

Even when information about commodity prices is included, the random walk model of deviations from PPP is still difficult to reject when explaining the behaviour of the real exchange rate over the managed exchange rate period. However, it is possibl.e to reject the random walk model of deviations from PPP if information about commodity prices is included (and adjustments for heteroskedasticity made) when explaining the behaviour of the real exchange rate over the floating rate period. (Whether defined in U.S. dollar or effective terms.)

In short the evidence is consistent with two propositions. First, when the exchange rate is not floating, PPP and commodity price considerations have no apparent systematic influence on the real exchange rate. Second, when the exchange rate for the Australian dollar is floating the behaviour of the real exchange rate is consistent with reversion to an equilibrium level modified by commodity price developments.