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Exchange rates and prices: sources of sterling real exchange rate fluctuations 1973-94

  • Mark S Astley
  • Anthony Garratt

This paper attempts to identify the sources of UK exchange rate and relative consumer price fluctuations between 1973 and 1994. We follow Clarida and Gali (1994) in using the Blanchard and Quah (1989) structural VAR (SVAR) method to identify the effects of three structural shocks within a Dornbusch (1976)/Obstfeld (1995) model. We find that IS shocks underlay the majority of the variance of sterling real and nominal exchange rates. Aggregate supply (AS) shocks were the second most important source of such variations, while LM shocks played an extremely limited role. In contrast, the variance of UK relative consumer prices was primarily attributed to LM shocks. Combining those results with the estimated impulse response functions indicates that the sterling exchange rate depreciations over the floating rate period were largely associated with falls in UK relative consumer prices. But it would be inappropriate for policy-makers to base any future policy response to sterling fluctuations on that finding because: (a) the Lucas critique applies to it; and (b) it represents the average dynamic interaction over the sample period. We also find that: (i) the estimated impulse responses following each of the shocks are highly theory-consistent; and (ii) the periods in which the SVARs suggest that particular shocks were especially important can be linked to observed macroeconomic developments. both those findings indicate that the SVAR representations of the data have a high economic content.

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Paper provided by Bank of England in its series Bank of England working papers with number 85.

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Date of creation: Oct 1998
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Handle: RePEc:boe:boeewp:85
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  1. Mussa, Michael, 1986. "Nominal exchange rate regimes and the behavior of real exchange rates: Evidence and implications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 25(1), pages 117-214, January.
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