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Pau Rabanal is an economist at the IMF Institute. Juan Rubio-Ramírez is professor of economics at Duke University. We thank George Alessandria, Boragan Aruoba, Sanjay Chugh, Giovanni Ganelli, John Haltiwanger, Federico Mandelman, Enrique Mendoza, Emi Nakamura, Jorge Roldós, John Shea, Pedro Silos, Jón Steinsson, Carlos Végh and seminar audiences at the University of Maryland, Banco de España CEPR/ESSIM meeting in Tarragona, CEMFI, and the Federal Reserve Banks of Atlanta, Dallas, and Philadelphia for useful comments. We also thank Hernán Seoane and Béla Személy for their research support. Beyond the usual disclaimer, we must note that any views expressed herein are those of the authors and not necessarily those of the International Monetary Fund, the Federal Reserve Bank of Atlanta, or the Federal Reserve System. Finally, Juan F. Rubio-Ramirez also thanks the NSF for financial support.
The RER in emerging markets can have a trend, in particular in those emerging economies that experience higher productivity growth rates than advanced economies. In that case, the use of a trend/cycle decomposition would be justified. However, the focus of most of the IRBC literature is to explain the RER of the U.S. dollar vis-a-vis other industrialized countries. In that case RERs are highly persistent series, but they do not have a trend.
In related work, Rabanal, Rubio-Ramírez and Tuesta (2011) show that cointegrated TFP shocks improve the model’s ability to explain certain features of the HP-filtered data, including RER volatility.
To save space, we do not repeat Figure 1 for the rest of the major currencies, but they are available upon request
For a description see http://www.federalreserve.gov/releases/H10/Weights/.
Rabanal, Rubio-Ramírez and Tuesta (2011) show that TFP processes between the U.S. and a sample of main industrialized countries are cointegrated and that the low estimated speed of convergence to the cointegrating relationship is a key ingredient for the model to explain the volatility of the RER at BC frequencies. Here, we examine how the same model performs in explaining movements of the RER at all frequencies. Since the model is the same as in the above-mentioned reference, we just show the main functional forms and optimality conditions and refer the reader to the original paper for a detailed derivation.
The Φ (·) cost is introduced to ensure stationarity of the level of Dt in IRBC models with incomplete markets, as discussed by Heathcote and Perri (2002). In this baseline model we choose the cost to be numerically small, so it does not affect the dynamics of the rest of the variables. This will not be the case when we analyze some of the extensions.
Rabanal, Rubio-Ramírez and Tuesta (2011) found that when θ = 0.85, this exact same model can explain only about half of the volatility of the HP-filtered RER.
Obstfeld and Rogoff (2000) analyze the role of transportation costs (in the form of iceberg costs) in explaning several puzzles of international macroeconomics. However, they conclude that this type of friction alone cannot solve the puzzle of high volatility of real exchange rates, which they label “the exchange rate disconnect puzzle.” In equation (18), the efficiency of the imported input is not a constant parameter as in Obstfeld and Rogoff (2000) and can help in explaining the behavior of the RER.