The Political Economy of Real Exchange Rate Behavior: Theory and Empirical Evidence for Developed and Developing Countries, 1960-2010

Empirical results of the PPP hypothesis have constantly shown that relative prices do not converge to the same level, neither in the short nor the long run. Therefore the PPP explanation of the determination of the real exchange rate is not operative to get a reasonable measure of competitiveness at the international level. In this paper, we put forth a different approach based on the works of Ricardo, Marx, Harrod, and Shaikh, which argues that the real relative unit labor cost is the main force that explains the long-run behavior of the real exchange rate. In the second section of the paper we explain the theoretical underpinnings of our proposed approach. In the third section we analyze the role of the real interest rate differential in explaining real exchange rate misalignments. In the fourth section, we present a graphical analysis of the interrelation among the real effective exchange rate, the real unit labor cost ratio, the short-run real interest rate differential, and the trade balance for sixteen OECD countries, Taiwan, and three developing countries for the period 1960-2010. In the fifth section we investigate the long-run relationship between the latter three indexes through cointegrating and error correction models using the ARDLECM framework. The last section provides our conclusions.