Back Matter
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

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A Appendix

A.1 Data Sources

Our sample includes 35 developed and emerging market economies: Australia, Austria, Belgium, Bulgaria, Canada, China, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Israel, Italy, Japan, Korea, Latvia, Lithuania, Netherlands, New Zealand, Norway, Poland, Portugal, Russia, Slovak Republic, Slovenia, South Africa, Spain, Sweden, Switzerland, United Kingdom, United States.

We collect the data from multiple sources. As for the quarterly frequency data, bilateral nominal exchange rate is extracted from the IMFs Information Notice System (INS), while CPI and GDP deflator are from the International Financial Statistics (IFS).21. ULC is obtained from the OECD database for Hungary, Israel, Korea, New Zealand, Poland, and Slovenia, and from Haver for the rest of sample countries. Regarding the annual frequency data, bilateral nominal exchange rate and GDP deflator come from the WEO database, CPI from the INS, and ULC from the OECD database for Israel, Korea, and New Zealand as well as from Haver for the rest of countries. For the quarterly sample, if seasonally adjusted series is not available, we employ X12 seasonal adjustment toolkit to eliminate the seasonal component.

In addition, we gather quarterly and annual current account statistics from Haver and WEO, respectively. Export, import, and GDP series, both quarterly and annual, are from the WEO database. Commodity term of variable is taken from the External Balance Assessment (EBA) database at the IMF.

A.2 The Role of Home-Bias

One of the most important parameters in our simulation is the home bias, α, which governs to what extent the exchange rate dynamics will be passed through to price indices. Therefore, in this section, we examine how home bias shape the evolution of RERs and their relationship with external balance.

In Figure 6, we plot the impulse responses corresponding to no home bias (α = 0.5) to complete home bias (α = 1) with the color of lines going from blue to green. In the no home bias case, CPI-based RERs never response to productivity shock because of the same composition in these indices between two countries. As a result, there is no dynamics in external balance, neither. On the contrary, ULC/GDP deflator-based RERs show a significant depreciation in response to productivity increase, and it is resulted from the nominal rigidity in wage level. To the other side of the extreme, in the case of complete home bias, PPI- and ULC-based RERs perform in a similar fashion, while GDP deflator-based RER resembles CPI-based one well. In our parameterization, α takes the value of 0.75, which is large enough to generate the dynamics in external balance and small enough to distinguish ULC-based RER from the rest.

*

We are grateful to George Alessandria, Rudolfs Bems, Yan Carriere-Swallow, Luis Cubeddu, Jesper Linde, Nicolas Ernesto Magud, Steve Phillips, Stephanie Schmitt-Grohe, Martin Uribe, Shang-Jin Wei, Juan Yepez, and seminar participants at the 2017 AEA meetings in Chicago, Columbia, IMF, and the 2016 Fall Midwest Macroeconomics meeting for their helpful comments.

1

The weights are calculated using Global System which uses data on trade flows. In the calculation, three types of trade categories are included: commodities, manufacture goods and service (represented by trade in tourism). The overall weight is the weighted average of the three: λij=αMλijM+αCλijC+αTλijT.

2

This decomposition is done using the change in each variable as we have shown below their levels are not stationary.

3

A substantial difference between REER measures deflated by CPI and GDP-deflator is also high-lighted in Bems and Johnson (2015).

4

In the paper, we report estimation results with current account balance only. All the results with trade balance are qualitatively identical throughout the specification/samples, and are available on request.

5

Although there also appears slight difference in the estimated coefficients of the long-run domestic demand (LR_DD) and short-run domestic demand (SR_DD) variables across columns, this is not so stark as the one for the short-run REER variable throughout a battery of regression results reported throughout the paper.

6

The reason that we employ commodity terms of trade here is its exogeneity. The total terms of trade may add invite more endogeneity issue stemming from the pricing decision of producers.

7

Data available at the annual frequency from the IMF’s EBA dataset. Commodity terms of trade are calculated as the ratio of a geometric weighted average price of the main commodity exports to a geometric weighted average price of the main commodity imports. The commodity categories included are food, fuels, agricultural raw materials, metals, gold, and beverages, measured against the advanced economies manufacturing goods prices from WEO. These relative commodity prices of six categories are weighted by the time average of export and import shares of each commodity category in total trade (exports and imports of goods and services).

8
As a simple demonstration, suppose that the production of domestic intermediate goods uses N types of (domestic) inputs (and labor being the first of them) with a Cobb-Douglas technology.
Y=Πk=1NIkαkαkαk,where Σk=1Nαk=1
The cost minimization leads to
WL=α1MCYMC=ULC/α1
9

More details in Mano (2016).

10
Using a simple CPI construction as a geometric average of tradable and nontradable goods, we can obtain that overall REER is:
pt=αptN+(1α)ptTpt*=αptN*+(1α)ptT*lnREER=(st+ptTptT*)α(p^tNp^tT)

where p^ denotes the relative price

11
According to Alessandria and Choi (2016), the external-balance-to-GDP ratio can be expressed as:
XMY=XMX+M×X+MY12×lnXM×X+MYlnXMη[(2α1)lnP*P+lnY*Y]XMX+Mη2[(2α1)lnP*P+lnY*Y]
12

The original purpose of this model set-up in Obstfeld (2001) was to show that the absence of exchange rate pass-through to CPI is not necessarily inconsistent with the presence of the expenditure switching mechanism.

13

The complete markets framework is used in a large body of international macro literature, e.g. Devereux and Engel (2007), Gali and Monacelli (2005), Chari, Kehoe and McGrattan (2002)) etc. Also, a strand of papers show examples where the incomplete market and complete market models predicts similar equilibrium allocations and the transmission mechanism, for instance, Chari, Kehoe and McGrattan (2002) and Corsetti, Dedola and Leduc (2008).

14

Labor union is usually introduced in models with wage rigidity, for instance, Ferrero (2015), Schmitt-Grohé and Uribe (2012) among many others.

15

This seemingly ad-hoc monetary policy can be derived from money-in-utility framework with U=C1ρ1ρκνLν+1χln(M/P), and it is the same as Devereux and Engel (2007).

16

For instance, Coeurdacier, Kollmann and Martin (2009) set it to be between 0.6 and 2, while Heathcote and Perri (2013) Obstfeld and Rogoff (2005) consider a value of 0.9 and 2, respectively.

17

See Schmitt-Grohé and Uribe (2016) for more details.

18

These standard deviations align with the values in literature, for instance, Gali and Monacelli (2005), Carvalho (2006) etc.

19

The extent to which GDP deflator-based RER depreciates is closely related to the level of home bias. As home bias becomes smaller, GDP deflator-based RER behaves more similarly to ULC counterpart; as home bias goes to 100%, GDP deflator-based RER coincides with CPI counterpart. More details can be found in Appendix A.2.

20

In each period, we generate a realization of At and Mt from their normal distribution and calculate the value of At, Mt and the rest of the model using the conditions (1) to (7).

21

South Africa’s GDP deflator comes from the World Economic Outlook (WEO) database

Real Exchange Rate and External Balance: How Important Are Price Deflators?
Author: Mr. JaeBin Ahn, Rui Mano, and Jing Zhou