Commonality and Heterogeneity in Real Effective Exchange Rates: Evidence from Advanced and Developing Countries

In order to differentiate between commonality and heterogeneity in real effective exchange rates, which are considered a measure of external competitiveness, we decompose their movements into global and country-specific factors using the Bayesian factor model. First, we show a complex but often positive relationship between real exchange rates and net trade volume using panel data of developed and developing countries. Then we report a particular global trend in real exchange rates, but a substantial proportion of their variation is found to be country-specific. In line with this finding, we conclude that structural shifts, when they do exist, are considered country-specific factors. Furthermore, consistent with economic theory, this global factor is closely related to a trend in the global interest rate, while country-specific factors are closely related to idiosyncratic movements in the countries' own interest rates. Such a decomposition results in better model performance in terms of coefficient signs, and therefore our results suggest that external competitiveness is heterogeneous among countries and that economic policy can influence countries’ competitiveness.