The Puzzling Behavior of Real Exchange Rates

The classic explanation for the persistence and volatility of real exchange rates is that they are the result of nominal shocks in an economy with sticky goods prices. A key implication of this explanation is that if goods in different sectors differing degrees of price stickiness then goods in the relatively sticky sectors tend to have relatively more persistent and volatile good-level real exchange rates. Using panel data, we find only modest support for these key implications. The predictions of the theory for persistence have some modest support: in the data, the stickier is the price of a good the more persistent is its real exchange rate, but the theory predicts much more variation in persistence than is in the data. The predictions of the theory for volatiity fare less well: in the data, the stickier is the price of a good the smaller is its conditional variance while in the theory the opposite holds. An alternative explanation is that the real exchange rates are driven by real productivity shocks, so that goods with more volatile and persistent real exchange rates should be in sectors with more volatile and persistent productivity shocks. We find little evidence for this explanation as well. In sum, cross section data is puzzling for existing models of real exchange rates.