Front Matter Page

Research Department

Table of Contents

• Summary

• I. Introduction

• II. Illustrative Model

• III. Econometric Methodology

• IV. Empirical Results

  • 1. United States

  • 2. Japan

• V. Concluding Remarks

• Appendix: Solution Method

• References

• List of Tables

• Table 1. Tests of Order of Integration

• Table 2a. Johansen Maximum Likelihood Tests: United States, 1950-90

• Table 2b. Estimated Cointegration Vector: United States, 1950-90

• Table 2c. Tests of Exclusion Restrictions: United States, 1950-90

• Table 2d. Tests of Joint Exclusion Restrictions: United States, 1950-90

• Table 3a. Johansen Maximum Likelihood Tests: Japan, 1951-90

• Table 3b. Estimated Cointegration Vector: Japan, 1951-90

• Table 3c. Tests of Exclusion Restrictions: Japan, 1951-90

• Table 3d. Tests of Joint Exclusion Restrictions: Japan, 1951-90

• List of Figures

• Figure 1: U.S. Real Exchange Rate Actual and Trend Values, 1951-1989

• Figure 2: U.S. Real Exchange Rate Cyclical Component, 1951-1989

• Figure 3: Japan Real Exchange Rate Actual and Trend Values, 1952-1989

• Figure 4: Japan Real Exchange Rate Cyclical Component, 1952-1989

• Appendix Figures

• Figure A1: Time Series Data (United States, 1950-90)

• Figure A2: Time Series Data (Japan, 1951-90)

Summary

This study investigates the sources of long-run movements in the real exchange rate. For the United States and Japan, significant trends in their real exchange rates remain as prominent stylized facts of the postwar era, although the long-term drift in each case has been in opposite directions. In the case of the United States, there has been a steady overall decline in the real value of the dollar, whereas Japan has experienced extraordinary real appreciation in the yen since World War II.

To account for long-run relative price movements, this paper implements a version of the macroeconomic balance approach, emphasizing the stock-flow determination of the real exchange rate compatible with internal and external balance. Viewing purchasing power parity (PPP) as a fixed steady-state condition rather than as a long-run equilibrium condition, the analytical framework allows the long-run real exchange rate to be affected by real disturbances—representing fundamental shifts in the relative prices compatible with international equilibrium.

Using postwar data for the United States and Japan, cointegration analysis is used to examine the long-run co-movements between the real exchange rate and a set of fundamental determinants. Cointegration tests suggest a deterministic long-run relationship between the structural components in the current and capital accounts—underlying a country’s net trade and net foreign asset positions—and the real exchange rate for these countries.

Specifically, cointegration estimates provide strong evidence that productivity differentials explain a significant portion of the trend variation in the real value of both the dollar and the yen. For the United States, there is also supporting evidence that the stock of net foreign assets has had an impact on the long-run real exchange rate. In both cases, there is little empirical support for the terms of trade determining the long-run path. The empirical analysis also provides estimates for the underlying stochastic trend in the real exchange rate for the United States and Japan, conditional on the empirically relevant fundamentals.