Estimating exchange rate responsiveness to shocks

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Abstract

The goal of this paper is to examine the importance of permanent and transitory shocks using a more efficient trend-cycle decomposition of the real exchange rate series. Our main contribution is that in measuring the impact of shocks, we not only impose common trend restrictions but also common cycle restrictions. We later confirm, through a post sample forecasting exercise, the efficiency gains from imposing common cycle restrictions. Our results indicate that permanent shocks are responsible for the bulk of the real exchange rate variations for Japan, Italy, Germany, France, and the UK vis-à-vis the US dollar over short horizons. For Canada, however, transitory shocks are dominant over the short horizon. In sum, while for Japan, France, and Italy, around 15% of the variation in real exchange rate is due to transitory shocks, for Canada, Germany and the UK, over 25% of the variations over the short horizon are due to transitory shocks. Thus, we claim that the role of transitory shocks should not be ignored.

Original languageEnglish
Pages (from-to)338-351
Number of pages14
JournalReview of Financial Economics
Volume17
Issue number4
DOIs
Publication statusPublished - Dec 2008
Externally publishedYes

Keywords

  • Permanent and transitory shocks
  • Real exchange rates
  • Trend-cycle decomposition

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