RDP 9309: Alternative Concepts of the Real Exchange Rate: A Reconciliation 5. Summary and Conclusions

In this paper an attempt has been made to reconcile two alternative forms of the real exchange rate: that based on domestic relative prices and that based on deviations from purchasing power parity. It was shown analytically that the two forms of the real exchange rate will only move similarly under restrictive conditions – namely, that the law of one price holds and relative prices are constant in foreign economies. It was argued that, in the short run, departures from the law of one price would contribute to differential movement between the two forms of real exchange rate. More importantly, it was shown that changes in the terms of trade or sectoral differences in productivity growth are likely to cause a systematic divergence between the two forms of the real exchange rate.

Estimates of domestic relative prices and deviations from PPP were presented for Australia and a number of foreign economies. Propositions regarding the relationship between them were, in general, supported by the data. Relative prices were shown to vary abroad, contributing to divergence between the two forms of real exchange rate. In fact, a tendency for a secular rise in the relative price of non-tradeables was evident in most countries, consistent with the hypothesis of faster productivity growth in the traded goods sector than in the non-traded goods sector. However, when large movements in both forms of the real exchange rate occurred within a short period of time, the driving force was the terms of trade. Furthermore, for countries whose terms of trade are driven by changes in import prices, it was found that both measures of the real exchange rate moved in the same direction: they were positively correlated with the terms of trade. In contrast, for countries whose terms of trade are driven by export prices, it was found that the two measures of the real exchange rate moved in different directions: relative prices were negatively correlated with the terms of trade whilst the real value of the currency was positively so. Certainly, for Australia, as a commodity exporting nation, divergent movements of the two measures of the real exchange rate were greatest at the time of major changes in the nation's export prices.

These findings raise several issues relevant to the policy maker. These issues centre on the proper interpretation of relative price movements and the efficacy of seeking to alter them.

For some time in public debate, it has been argued that the rise in the relative price of non-tradeables in Australia warrants nominal depreciation of the currency. The argument is along the lines that the trend rise in the relative price of non-tradeables has reduced the competitiveness of the traded goods sector and, hence, led to a larger current account deficit. While the argument that, if all else remains the same, high relative prices of non-traded goods reduce the competitiveness of the traded goods sector is true, all else has not remained the same. In Australia, as elsewhere, the relative price of non-tradeables has shown a secular increase reflecting faster productivity growth in the traded goods sector than in the non-traded goods sector. In fact, the faster is such productivity growth, the faster is the increase in the relative price of non-tradeables likely to be. It is, therefore, incorrect to conclude, simply on the basis of an observed rise in the relative price of non-tradeables, that the Australian dollar is overvalued.

In the short run, however, relative prices can be altered by monetary policy. For instance, an unexpected easing of monetary policy is likely to result in depreciation of the nominal exchange rate. Assuming some (if not instantaneous) exchange rate pass-through, this will lower the relative price of non-tradeables. With sticky prices, it will also depreciate the PPP based real exchange rate. These falls in the measures of the real exchange rate will generate improvements in competitiveness. Indeed, this improvement in competitiveness is an important part of the monetary transmission mechanism. But, the important point to stress is that this improvement in competitiveness will be only temporary, dissipating as the price of non-traded goods rises and relative prices are restored. In some cases, policy makers may wish to engineer such temporary changes in competitiveness. Repeated attempts will, however, result in a sustained increase in inflation and no improvement in competitiveness.

In the longer run, changes in the real exchange rate measures are driven by fundamentals such as shifts in productivity and the terms of trade: they are endogenous and independent of monetary policy. This does not mean that government policy cannot indirectly influence the real exchange rate. However, only actions of government directed at altering the real economy will influence the real exchange rate in a sustainable way. Ultimately, efficiency gains that increase the ability of the traded goods sector to attract resources from competing sectors (both domestic and foreign) will induce appreciation of the real exchange rate, however defined.