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Real exchange rates and the relative prices of non-traded and traded goods: an empirical analysis

  • Jan J J Groen
  • Clare Lombardelli

This paper provides an empirical analysis of the decomposition of UK real exchange rates into the relative price of traded goods and the ratio of the relative price of non-traded to traded goods, and tests the prediction that deviations from the law of one price in tradable goods dominate real exchange rate variability only in the short run. UK bilateral real exchange rates are examined relative to a sample of six main OECD partners. The existence of a long-run relationship between real exchange rates and these corresponding relative price ratios is analysed using cointegrated vector autoregressive models. These show only limited evidence of a cointegrating relationship. The paper quantifies the severity of the deviations from the law of one price, and shows that these deviations are persistent relative to the length of the sample period. This motivates the use of a multi-country panel cointegration-testing framework, which produces evidence of a long-run relationship between the real exchange rate and the non-tradable component.

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File URL: http://www.bankofengland.co.uk/research/Documents/workingpapers/2004/WP223.pdf
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Paper provided by Bank of England in its series Bank of England working papers with number 223.

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Date of creation: Jun 2004
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Handle: RePEc:boe:boeewp:223
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  1. Beyer, A. & Doornik, J.A. & Hendry, D.F., 2000. "Constructing Historical Euro-Zone Data," Economics Working Papers eco2000/10, European University Institute.
  2. Gianluca Benigno & Christoph Thoenissen, 2003. "Equilibrium Exchange Rates and Supply-Side Performance," Economic Journal, Royal Economic Society, vol. 113(486), pages C103-C124, March.
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  11. Georgios E. Chortareas & Rebecca L. Driver, 2001. "PPP and the real exchange rate-real interest rate differential puzzle revisited: evidence from non-stationary panel data," Bank of England working papers 138, Bank of England.
  12. Johansen, Soren, 1991. "Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models," Econometrica, Econometric Society, vol. 59(6), pages 1551-80, November.
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  29. repec:dgr:uvatin:19990055 is not listed on IDEAS
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