Short‐run Real Exchange Rate Dynamics

Abstract

The short‐run dynamics of German mark and US dollar real exchange rates are investigated for a panel of 19 OECD economies in a vector error correction framework for the 1973‐96 period. The novel persistence profiles approach of Pesaran and Shin (‘Cointegration and Speed of Convergence to Equilibrium’, Journal of Econometrics, Vol. 71, (1996), pp. 117–143) indicates that the effect of system‐wide shocks declines rapidly initially but decays slowly thereafter. It yields an average of just one year for the half‐life of such shocks but some seven years before they fully dissipate. These half‐life estimates are just one‐quarter of the consensus estimates. Our results are consistent with non‐linear adjustment and with monetary factors being the main source of real exchange rate volatility.

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