Explaining Real Exchange Rates Fluctuations

This paper attempts to explain the sources of real exchange rate fluctuations for a set of advanced economies and Central and Eastern European transition economies. To address this, firstly, we compute two measures of the share of the variance in the real exchange rate accounting for movements in the relative prices of traded goods between countries. Secondly, we estimate structural (identified) vector autoregression (SVAR) models, and decompose real and nominal exchange rate movements into those caused by real and nominal shocks. Thirdly, we complete the previous steps with an impulse-response analysis. The results suggest that: (1) for transition economies, under regimes of managed nominal exchange rates, the relative price of non-traded goods explains a large percentage of the variance in the real exchange rate; (2) there is evidence of instability in the variance decomposition of real exchange rates for advanced economies across samples; and (3) as result of diverse fiscal and monetary policies in transition economies, real exchange rates in some economies are driven mostly by real shocks while in others they are driven mostly by nominal shocks.