RDP 9309: Alternative Concepts of the Real Exchange Rate: A Reconciliation 1. Introduction

The real exchange rate has occupied a prominent place in both theoretical and policy debate during the last decade. The widespread reference to the real exchange rate stems, in large part, from the belief that it is a useful summary measure of key economic information. For instance, it is commonly used as a measure of competitiveness of the traded goods sector and even as a measure of the standard of living in one country relative to another. In addition, changes in the real exchange rate are seen as an important part of the adjustment process to real shocks. Given the importance of the real exchange rate, there is surprisingly little agreement concerning both how to measure and interpret movements in it. In large part, disagreement stems from the fact that the term ‘real exchange rate’ has been applied to two different concepts.

The traditional form of the real exchange rate is that based on deviations from purchasing power parity (PPP). This measure came to prominence at the end of World War I with estimations by Cassel (1918) and has been used widely both in Australia and internationally. The other form of real exchange rate has evolved from the theoretical model of a dependent economy and is based on the ratio of domestic prices of non-tradeables to tradeables. It is most often associated with Salter (1959) and Swan (1960, 1963). Despite the equilibrating role afforded to domestic relative prices in theoretical models of open economies, practical difficulties associated with the estimation of such prices have resulted in widespread adoption of the PPP based measure of the real exchange rate. Typically, movements in it have been presumed to be indicative of changes in domestic relative prices (O'Mara, Carland and Campbell 1980).

However, over recent years, a variety of estimates of domestic relative prices have become available for Australia.^[1] All relative domestic price series indicate that during the last five years the relative price of non-traded goods has risen. This finding is in contrast to the real depreciation suggested by deviations from PPP. The two forms of real exchange rate appear to give countervailing signals. How should such signals be interpreted? In this paper, an attempt is made to reconcile different measures and interpretations of the real exchange rate.

First, it is shown that the two forms of the real exchange rate will only generate similar results under extremely restrictive assumptions; most importantly, unchanging relative prices abroad. In most nations this condition is violated. Relative prices, both at home and abroad, may change for a variety of reasons. In this paper, two sources of change are considered: productivity growth in the traded goods sector, and movements in the terms of trade. Second, it is argued that proper interpretation of movements in real exchange rates requires consideration of the source and permanency of the change in relative prices both at home and abroad.

The paper is organised as follows. In Section 2, there is a brief theoretical exposition of the relationship between the two forms of the real exchange rate. In Section 3, sources of divergent movements in the two measures are identified. In particular, the implications of changes in the terms of trade and productivity for alternative measures of the real exchange rate are explored. In Section 4, different estimates of Australia's real exchange rate are presented. Disparate movements in various published estimates of the real exchange rate are appraised and shown to contain valuable information about developments in both the Australian and foreign economies. Finally, in Section 5, conclusions and policy implications are drawn.

Footnote

See for example Shann (1982), Pitchford (1986), Dwyer (1991, 1992) and Lattimore (1988). [1]