Variation in nominal and real effective exchange rates: evidence across developed and developing countries

Recent episodes of excessive volatility in the foreign exchange market have brought to the fore the interest in studying the transmission mechanism of global uncertainty on the domestic economy. At the core is the degree of adjustment in the exchange rate as a shock absorber and the impacts of domestic policies in mitigating the spillover effects of global volatility. Using data for a sample of advanced and developing countries, the paper studies the responses of the nominal effective exchange rate, the real effective exchange rate, and price inflation to domestic and external sources of economic shifts. Subsequently, the analysis evaluates the degree of correlations between the responses of these variables to each economic shift. The objective is to study sources of movements in the real effective exchange rate and bilateral nominal exchange rates versus price inflation. The analysis then turns to evaluation of the determinants across countries of the time-series correlations between the change in the real effective exchange rate and its underlying components—nominal change and inflation—within countries over time. Cross-country regressions establish the relevance of the trend and variability of each of price inflation, the change in the nominal exchange rate, and the change in the real exchange rate on the degree of association between each pair. The evidence attests to a high pass-through from fluctuations in the nominal exchange rate to price inflation, which is more pronounced in developing countries, attesting to the need to target the real effective exchange rate as a framework for monetary policy.