Real exchange rate dynamics beyond business cycles

We examine the determinants of medium-run movements in real exchange rates. Using historical US–UK and cross-country data, we find that the real exchange rate co-moves with GDP at medium-run frequencies and the co-movements are significantly weakened by banking crises. This relationship can be rationalized by an extension of the IRBC model with non-stationary productivity shocks and risk-averse financial intermediaries, where crises increase intermediary risk aversion. Using a global solution method, GDSGE, we demonstrate that the transmission of productivity shocks depends critically on the international borrowing capacity which is hindered by banking crises. The mechanism differs from the Harrod–Balassa–Samuelson effect which does not generate these state dependent co-movements.