Journal of International Money and Finance, Vol. 16, No. 2, pp.

233 254, l qt~7

Pergamon
PIh

1997 Elsevier Science Ltd. All rights reserved Printed in Great Britain S0261-5606(96)00054-X 0261-5606/97 $17.00 + I).O0

Accounting for real and nominal exchange rate movements in the post-Bretton Woods period
WALTER ENDERS*

Department of Economics, Iowa State University,Ames IA 50011, USA

AND BONG-SOO LEE

Department of Finance, College of Business Administration, University of Houston, Houston TX 77204-6282, USA
Using the technique developed by Blanchard and Quah, we decompose real and nominal exchange rate movements into the components induced by real and nominal factors. Nominal shocks have had a minor effect on the real and nominal bilateral exchange rates between the US and Canada, Japan and Germany. There is little evidence of exchange rate overshooting. Real demand, rather than supply, shocks have been responsible for volatile exchange rate movements; structural models of exchange rate determination need to consider such shocks as an important 'fundamental' determinant. (JEL F31). 1997 Elsevier Science Ltd.

At a minimum, a structural model of exchange rate determination should be able to isolate those variables responsible for real and nominal exchange rate movements. However, the lengthy rise in the dollar from the late 1970s through mid-1985 followed by the sustained depreciation is difficult to reconcile with the so-called 'fundamentals' suggested by the structural models. In fact, there is mixed evidence supporting the existence of a well-defined set of fundamentals. Baillie and Selover (1987), Baillie and McMahon (1989) and Kim and Enders (1991), for example, provide evidence that for the United States, there are no long-run equilibrium (i.e. cointegrating) relationships between bilateral exchange rates and various combinations of relative money supplies, interest
*This paper was written while Walter Enders was a Visiting Professor at the University of Glasgow. Important suggestions were made by members of workshops at the Institute for International Studies (Geneva, Switzerland), Strathclyde University (Glasgow, Scotland), and the University of Dundee. We thank two anonymous referees of this journal for their helpful comments and suggestions. All remaining errors are our own.
233

Real and nominal exchange rate mooements in the post-Bretton Woods period: W Enders and B-S Lee

rate differentials, and measures of relative productivity. More recently, papers by MacDonald and Taylor (1993, 1994) and Dibooglu and Enders (1995) employ the Johansen methodology to identify cointegrating relationships consistent with a monetary model of the exchange rate. ~ The limited support of exchange rate models to establish the causes of real and nominal exchange rate movements leads us to seek an alternative methodology. Rather than regressing the exchange rate on various other macroeconomic variables, we use a modification of the technique developed by Blanchard and Quah (1989) in an attempt to decompose historical exchange rate movements into the changes induced by real versus nominal factors. In Section I, we first discuss the time series properties of national price ratios and the bilateral real and nominal exchange rates between the United States and three of its major trading partners (Canada, Japan and Germany). We then formalize the circumstances in which the underlying shocks can be identified and show how the exchange rate series can be decomposed into movements caused by real shocks versus those caused by nominal shocks. Section II shows how the decomposition is consistent with a broad class of structural models and discusses some possible limitations of the methodology. Section III presents our principal findings. To preview our results, we find that both real and nominal exchange rate movements are primarily caused by real shocks. In Section IV, we attempt to explain the historical decompositions and to reconcile our findings with the structural models. Our results imply that studies testing and estimating the structural models are often flawed in that they omit the role of demand-side shocks as an important 'fundamental' determinant of both real and nominal exchange rates. At a more basic level, the results are suggestive of an explanation for the so-called failure of Purchasing Power Parity (PPP) during the post-Bretton Woods period; Adler and Lehman (1983), Corbae and Oulairis (1988), and Enders (1988) have argued that US bilateral real rates follow a non-stationary process. We view these findings complimentary to those of Engel and Hamilton (1990), Perron (1989) and Perron and Vogelsang (1992). Using univariate time-series methods, there appears to be a structural break or regime change in various real exchange rate series around mid-1985. However, the authors' univariate methodologies cannot ascertain the variable(s) responsible for the regime change. In our interpretation, a change in real demand-side behavior (possibly due to the behavior of real US federal government expenditures) can account for the univariate finding of a structural change. The final section summarizes our results.
I. Data and identification

The real and bilateral exchange rates between the United States and Canada, Japan and Germany for the post-Bretton Woods period are shown in Figure 1.2 The consensus opinion in the literature (see Corbae and Oulairis, 1988; Enders, 1988; or MacDonald, 1993) seems to be that real and nominal exchange rates during this period can be well approximated by unit root processes. To briefly reconfirm this opinion, we present the autocorrelation
234

Real and nominal exchange rate movements in the post-Bretton Woods period: W Enders and B-S Lee

(a)
1.44 t 1.26 1.08 1 0.90 73 76

. . . . . . . .
79 82 85

7?;
88 91

(b)
5.0 4'0 t 3.0

2.0 1.0
(c)

73

76

79

82

85

88

91

360 300 240 180 120

73

76

79

82

85

88

91

FIGURE 1. Nominal and real exchange rates: Canada, Germany and Japan. (a) Nominal and real Canadian dollar; (b) Nominal and real German mark; (c) Nominal and real Japanese

yen.

nominal rates; . . . .

real rate.

functions for real and nominal exchange rates in Table 1. The slow decay for the various series is consistent with the null of a unit root. In Table 2 we report Dickey and Fuller (1979) unit root tests on the exchange rate series. Consistent with most other studies focusing on the post-Bretton Woods period, the test statistics in Table 2 do not allow us to reject a null of a unit root. We also test the proposition that the ratio of U S / f o r e i g n wholesale prices is non-stationary. Table 1 shows that the autocorrelation function of the ratio of U S / f o r e i g n prices has the classic signs of a non-stationary process. The formal Dickey-Fuller (1979) tests performed in Table 2 substantiate this impression. Since the ratio of prices is non-stationary, the bilateral pairs of real and nominal exchange rates cannot be cointegrated. Note that it is not the purpose of this paper to determine whether or not PPP holds over very long-run periods. It may be that real rates are stationary and our sample period is not sufficiently long enough to detect the presence of mean reversion. Alternatively, the behavior of real rates in the post-Bretton Woods period may actually be different from that in earlier periods. Since our aim is to explain recent exchange rate movements and since the data within this period appear to be non-stationary, we proceed as if real rates are non-stationary. Notice that in the short-term, real and nominal rates move together; in particular, the turning points of the series coincide. The essential point to note is that over time the real and nominal rate series diverge. Our interpretation of Figure 1 is that there are two types of shocks affecting real and nominal exchange rates. 3 One of the shocks, which we call a 'real' shock, affects both real and nominal rates in a similar fashion. This would account for the similar short-run paths shown in Figure 1. A second type of shock, which we call a 'nominal' shock, affects the two exchange rates differentially. Consistent with
235

Real and nominal exchange rate mouements in the post-Bretton Woods period: W Enders and B-S Lee
TABLE 1. Autocorrelations (1973:1-1992:4)

p(k)

k= 1

10

11

12

(A) Without first differencing Canada NominalCD 0.99 ReaICD 0.99 Price ratio 0.99 Germany N o m i n a l D M 0.98 RealDM 0.98 Price ratio 0.98 Japan Nominal JY RealJY Price ratio 0.99 0.98 0.99 0.98 0.97 0.98 0.95 0.96 0.97 0.97 0.95 0.98 0.97 0.95 0.97 0.92 0.93 0.95 0.96 0.92 0.97 0.96 0.94 0.95 0.89 0.90 0.94 0.94 0.89 0.96 0.94 0.92 0.94 0.86 0.87 0.92 0.92 0.85 0.95 0.93 0.90 0.93 0.84 0.85 0.90 0.91 0.81 0.94 0.92 0.88 0.92 0.82 0.82 0.88 0.89 0.78 0.93 0.91 0.86 0.92 0.80 0.80 0.86 0.87 0.75 0.92 0.90 0.84 0.91 0.77 0.77 0.84 0.86 0.71 0.90 0.88 0.82 0.90 0.75 0.75 0.82 0.84 0.68 0.89 0.87 0.80 0.89 0.72 0.72 0.81 0.82 0.65 0.88 0.85 0.77 0.88 0.69 0.69 0.79 0.80 0.61 0.86

(B) With first differencing Canada Nominal CD 0.18 - 0 . 0 5 0.08 0.09 0.00 0.02 0.03 Real CD 0 . 1 7 - 0 . 1 1 - 0 . 0 2 0.07 0 . 0 2 - 0 . 0 3 - 0 . 0 5 Price ratio 0.31 0.07 0 . 0 5 - 0 . 0 5 - 0 . 1 0 - 0 . 0 9 - 0 . 0 4 Germany Nominal DM 0.30 Real DM 0.29 Price ratio 0.53 Japan Nominal JY Real JY Price ratio 0.32 0.28 0.54 0.07 0.05 0.30 0.01 0.02 0.25 0.09 0.06 0.21 0.08 0.07 0.15 0.01-0.05-0.05 0.02-0.03-0.05 0.16 0.10 0.05 0.11 0.13 0.08 0.03 0.03 0.12

0.13 0.19 0.03 0.01 0.01 0.15

0.02 0.04 0.10 0.04 0.02 0.15

0.17 0.08 0.02 0.10 0.09 0.08

0.10-0.03 0.04-0.04 0.02 0.10 0.03 0.03 0.10 0.03 0.01 0.16 0.09 0.06 0.04

0.03-0.08 0.00 0.04 0.01-0.02 0.08 0 . 0 7 - 0 . 1 3 - 0 . 0 7 0.08 0.02 0.00 0.07 0.03 - 0.01 - 0 . 0 2 - 0 . 0 6 - 0.02 - 0.04 - 0.03

Notes: p ( k ) denotes autocorrelation between x t and xt_ k. CD: Canadian dollar; JY: Japanese yen; and DM: German mark. Price ratio is compared as US price/foreign country price. Variables are in logs.

the notion of long-run money neutrality, we allow the nominal shocks to have a temporary, but not a permanent, effect on real exchange rates. This assumption is consistent with most structural models of exchange rate determination and serves as the identifying restriction allowing us to decompose the exchange rate series. Notice that we do not restrict the relationship between nominal shocks and the nominal exchange rate or the relationship between real shocks and either the real or nominal rate. The decomposition also requires that the two shocks be mutually uncorrelated at all leads and lags. 4 Given the evidence concerning the non-stationarity of the US real and nominal exchange rates, we represent them as being characterized by unit root

236

Real and nominal exchange rate movements in the post-Bretton Woods period: W Enders and B-S Lee
TABLE 2. Unit root test: sample period 1973:5-1992:4 (monthly data) (Augmented Dickey-Fuller regression A x t = Ix + a x t_ , + F.3i i Yi Ax, i + et, T = 228) Variables (x t) Real CD DM JY CD DM JY a - 0.0142 - 0.0188 - 0.0216 -0.0095 - 0.0166 - 0.0042 - 0.0098 -0.0071 - 0.0007 ~ - 1.587 - 1.705 - 1.807 -1.520 - 1.684 - 0.682 - 1.348 -2.843 - 0.310 H0: a = 0 (non-stationary) Non-rejected at 10% Non-rejected at 10% Non-rejected at 10% Non-rejected at 10% Non-rejected at 10% Non-rejected at 10% Non-rejected at 10% Not rejected at 5% Not rejected at 10%

Nominal

Price ratio CD DM JY

Notes: CD: Canadian dollar; JY: Japanese yen; and DM: German mark. For the augmented D - F test, the critical values are r, = -2.57, at 10% significance level; ru = -2.88, at 5% signifcance level with 250 observations [see Fuller (1976, p. 373 Table 8.5.2)]. Price ratio is computed as US price/foreign country price. Variables are in logs.

processes. L e t Gt a n d Ent be the z e r o - m e a n m u t u a l l y u n c o r r e l a t e d real a n d n o m i n a l shocks, respectively. F o r m a l l y , a 2 1 v e c t o r o f t h e first d i f f e r e n c e s in real a n d n o m i n a l e x c h a n g e rates, z~ = [Art, A e t ] ' , c a n be r e p r e s e n t e d by t h e following bivariate m o v i n g a v e r a g e r e p r e s e n t a t i o n ( B M A R ) .

(i) or

z,-

[Ar,,Ae,]' =B(L)e,,

(2)

Aet]=[B2,(L),

BI2(L] , 1 II,r, B22(L)j[em

w h e r e : 1", = real e x c h a n g e rate in time p e r i o d t; e, = n o m i n a l e x c h a n g e rate in t; e I = [ % , e,,t]'; e,t = real s h o c k in t; ent = n o m i n a l s h o c k in t; B i i ( L ) f o r i, j = 1, 2 is a n i n f i n i t e - o r d e r p o l y n o m i a l in t h e lag o p e r a t o r L ; A is t h e first-difference o p e r a t o r ; a n d t h e i n n o v a t i o n s are n o r m a l i z e d s u c h t h a t V a r ( e , ) =I. T h e t i m e p a t h s o f t h e effects o f the v a r i o u s s h o c k s o n t h e real a n d n o m i n a l e x c h a n g e r a t e s are i m p l i e d by the coefficients o f t h e p o l y n o m i a l s B i j ( L ) . T h e restriction t h a t the n o m i n a l s h o c k s h a v e n o l o n g - r u n effect o n the real e x c h a n g e r a t e is r e p r e s e n t e d by the restriction t h a t t h e s u m o f the coefficients in B 1 2 ( L ) s u m to z e r o ; thus, if b i j ( k ) is t h e k - t h c o e f f i c i e n t in B i j ( L ) : (3> B , 2 ( L ) ~ Y', b l 2 ( j ) g J ; j=0 Y', b l 2 ( j ) = B,2(1) = 0. j=0

Since b , 2 ( j ) is the effect o f e n o n A r a f t e r j p e r i o d s , Ef=o b , 2 ( j ) is the

~7

Real and nominal exchange rate movements in the post-Bretton Woodsperiod: W Enders and B-S Lee cumulative effect of E,, on Ar over time. Similarly, because (4)
r t = (1 - L ) - 1B11(L) rt
k
q- (1 --

L)k

1B12(L) en, ,

= E

E bll(J)Ert-j "~ E

E bl2(J)'nt-j,

k=0 j=0

k=0j=0

E~=o b l z ( j ) is the effect of e, on r after infinitely many periods, which means the effect of % on r in the long run. Consequently, the restriction that B12(1)- ET=ob12(j) = 0 implies that the cumulative effect of e, on ~Xr over time is zero, and that the long run effect of e, on r is zero. Put another way, the nominal shock % has only short-run effects on real exchange rate, whereas the real shock er may have long-run effects. In fact, the BMAR model (1) is derived by inverting a bivariate autoregression (BVAR) model. We therefore discuss how to impose restrictions on the BVAR model in such a way as to ensure that B12(1)= 0 in the BMAR. Suppose that we have the following BVAR model zt = [Art, Aet]': 5

<5) Z , ~ [Aet

=A(L)z,_~

+Or = [A21(L),

Ae2(L)

Act_ 1 --}- [ 132t

where ot = [vlt, Vz,]' = z t - E ( z t l z t _ , , s > 1), with var(v t) = Y'.. By inverting this BVAR of zt, we obtain a B M A R of zt:
(6) z t = (I -A( L )L )-tvt = k( L)vt,

where I is an identity matrix of rank 2. Since z t is a covariance stationary process, there exists a BMAR such as (6). By comparing the BMAR in (1) with that in (6), Blanchard and Quah (1989) show that the BMAR restriction B~e(1) = 0 is equivalent to the restriction on the BVAR: 6 (7) [I-A22(1)]b12(0)
+A12(1)b22(0) = 0,

where A22(1) ~ ~=0 azz(J) and A12(1) - E~=0 alz(J). The coefficients of B(s) in (2) represent 'responses to shocks (disturbances)' in particular variables. Since Et is now, by orthogonalization, serially and contemporaneously uncorrelated, we can allocate the variance of each element in z to sources in elements of e. For example,
t-I

<8)
s=0

b,j(s)2/ Y'.
j=l

t-I s=0

bi (s)

provides the components of error variance in the t-step ahead forecast of zi, which is accounted for by innovations (or disturbances) in z~.7 Once we estimate a restricted BVAR model of Ar t and A e t , we can also obtain a restricted BVAR model of r t and e t if we are interested in investigating the effects of each component on exchange rates rather than on the first differences in exchange rates.
238

Real and nominal exchange rate movements in the post-Bretton Woods period." W Enders and B-S Lee

To summarize, the Blanchard-Quah methodology allows us to decompose the movements in real a n d nominal exchange rates into the movements induced by 'real' versus 'nominal' shocks. The precise type of nominal shock is left unspecified; the nominal shock has the property that it has no permanent effect on the real exchange rate. Even if the real rate is treated as non-stationary, the restriction that the sum of the coefficients on current and lagged values of the nominal shocks in the real exchange rate equation necessitates that nominal shocks have no permanent effect on real rates (i.e. long-run money neutrality). The residual movements in the real rate are attributed to the real shock. Notice, however, that the factorization necessitates the use of two series to identify the two types of shocks; the variance and covariance of the residuals from both equations in the BVAR are used in identifying the two shocks. Moreover, in our decomposition the two fundamental shocks (i.e. e,,r and era) are contemporaneously uncorrelated by orthogonalization. The major problem with the decomposition is that the world economy is subject to many different types of shocks; in a 2 x 2 system it is possible to identify at m o s t t w o different types of shocks. This is true regardless of the factorization used unless other identification restrictions are imposed. To explain the issues involved, in the next section we use a discrete time variant of the well-known Dornbusch (1976) 'overshooting' model. We also use the model to demonstrate how the identification restriction is consistent with a wide class of open economy structural macroeconomic models.
II. An illustrative model

The international finance literature recognizes two distinct types of shocks and their differential impacts on real and nominal exchange rates. Real shocks, whether they emanate from changes in aggregate demand or aggregate supply, can affect both real and nominal exchange rates. Permanent changes in demand or supply will result in permanent changes in real and nominal exchange rates. On the other hand, nominal shocks, such as changes in the domestic money supply, can affect real variables only in the short-run but can affect other nominal variables in the long-run. Thus, a permanent change in the money supply can have a permanent effect on the nominal exchange rate but only a temporary effect on the real rate. This interpretation of shocks is in accord with many of the standard open economy macroeconomic models in international finance. We illustrate the differential effects on real and nominal shocks using the well known Dornbusch (1976) 'overshooting' model of a small open economy. We do not mean to imply that this model is the appropriate model of the US economy. Our intent is simply to illustrate the various types of shocks and the identifying restriction concerning the temporary nature of nominal shocks on real variables. Following Dornbusch (1976), let; (9) (10)
m t = P t + Y t -- Air,

A > O,

i t =i t +Et[et+ 1 -et] ,
239

Real and nominal exchange rate movements in the post-Bretton Woods period: W Enders and B-S Lee

(11) (12)

d t = Ty, + 6[et + p ? - P t ] + g t - o i t - Y t ,

0 < r < 1; P,+I - P t = 7rdt,

8, tr> 0, 7r> 0,

where: m = log of the domestic money supply; p = log of the domestic price level; y = log of domestic income ( = output); e = log of the domestic currency price of foreign exchange; i = domestic interest rate; d = excess demand pressure for the domestic good; g = log of real government purchases; t = time subscript; E t is the expectations operator conditional on the information available up to time t; and * denotes the foreign counterpart of a domestic variable. Equation (9) asserts that the demand for money (set equal to the money supply) is proportional to the domestic price level and domestic output and negatively related to the domestic interest rate. s Equation (10) is the uncovered interest parity condition equating the domestic interest rate with the foreign rate plus the expected rate of appreciation of the foreign currency. In equation (11), demand pressure [7"yt + 8( e t + p { --Pt) + gt - 'it] is positively related to domestic output and the relative price of the foreign good (i.e. et + P t --Pt) and negatively related to the domestic interest rate. Note that the variable g, is explicitly defined to be government purchases but it could represent any variable that acts to increase aggregate demand. Aggregate demand pressure less aggregate supply is the excess demand for the domestic good (dr). Equation (12) is the price adjustment equation; the price level rises (falls) in response to a positive (negative) level of excess demand pressure. The real exchange rate in period t (r t) is defined as: (13)
rt -- et + P t - P , .

In order to close the model, it is necessary to specify the time paths of the exogenous variables. Again, for illustrative purposes, we can allow: (14a) (14b) (14c) (14d) rnt+ l =m~ + emt+l,
Yt+ I = Y t + err+ I, gt+l = g , + egt+l, p?+, = p ; = ... = O,

where: %t+ 1 = shock to variable x in period t + 1. Our use of the 'small' country assumption is for expositional purposes only. Readers familiar with the international finance literature are well aware that it is trivial to generalize the model in order to consider the case of two 'large' countries. Assuming that behavioral parameters are identical across countries (e.g. A = A*, ~-= ~r*), the domestic country variables can be re-interpreted as referring to relative magnitudes. Thus, m t can be reinterpreted as the ratio of the domestic to the foreign money supply and y, can be reinterpreted as the ratio of the domestic to foreign output. In the two-country case, both domestic and foreign prices are endogenous: hence, p, refers to the ratio of domestic to foreign prices and equation (14d) is eliminated.
240

Real and nominal exchange rate movements in the post-Bretton Woods period: W Enders and B-S Lee

Notice that equations ( 1 4 a ) - ( 1 4 c ) are formulated such that the nominal and real shocks have only permanent components. Given an initial condition such that price in period 0 is P0, the time paths for the nominal and real exchange rates are given by:
t

(15)

e ~ = f l o ( ~ l ) t P o + f l o ( 1 - f l l ) ~-, (/31)k-I[mk 1--Yk-I]

k=l +(1 --

flo)mt + fl2Yt-g,/6,

(16)
t

rt=et-Pt=(flo-1)(fll)tpo+(flo-1)(1-fll)
+ (1 - / 3 0 ) m , + where ~0=(1/2){(1+o-/h6)-[(1+o-/A6) /31 = 1 + I / h ~ 0 ;

Y'~ (}1)
k=l

k-I

[rnk-l--Yk-l]

fl2Yt-gt/(~,
2 +4/~h6]I/2}<0,

/32 = (i - r ) / 8 + # / h 6 + i / ~ 0 ~ S h ,

and, by assumption: [fl0] < I; [fill < I. Before continuing) note that equations (9) through (12) are consistent with a wide variety of macro-models. For example) in the limit ~- -~ % so that d t -.->0 for each time period (t) and the goods market is always in equilibrium. In such a situation, money supply shocks affect only the nominal variables in the system. Real shocks (shocks to income or government purchases) can affect both the real and the nominal exchange rate. In addition, it is possible to consider the model when lira ~--) ~ so that g, +p~ - P t is a constant. The natural interpretation is that as 8--> % domestic and foreign goods approach perfect substitutes; the real exchange rate is always constant. In this case, purchasing power parity always holds; neither real nor nominal shocks alter the real exchange rate. Real and nominal shocks, on the other hand, will affect the nominal exchange rate. The: 'overshooting' result is obtained by obtaining the point in time comparative statics result: (17)

det/dm , = drt/dm ~= (1 -/30) > 1.

Thus, the initial changes in the nominal and real exchange rates are more than proportional to the initial change in the money supply. Hence, as long as /3o 4~ 0, the real exchange rate is also affected by the nominal shock. Ultimately, the money supply shock has a proportional effect on the nominal rate and no effect on the real exchange rate. From equations (15) and (16): (18) lim d e , + j / d m t = ~ o ( 1 - ~ , )
J~z

~ fl~-i + ( 1 _ / 3 0 ) = 1 ,
k=l

241

Real and nominal exchange rate movements in the post-Bretton Woods period: W Enders and B-S Lee
oc

(19)

lim d r t + j / d m t = ( / 3 o - 1 ) ( 1 - f l
J~

,) ~, fl~-~ + ( 1 - / 3 0 ) = 0 .
k=l

Income shocks and government expenditure shocks, on the other hand, have permanent effects on both the real and the nominal exchange rate. The point in time effect of an income shock on the real and nominal exchange rate is /32. In the limit: (20) (21)
l i m det+j/dEy t = (1 - T ) / 6 - 1

(ambiguous in sign),

j~oc

lim drt+j/dey t = (1 - ~')/6 > 0.

For government expenditure shocks, the point in time and steady state effects of government expenditure shocks are identical since both the nominal and real rates 'jump' to their long-run value. (22) (23)

det/dg t = jlim det+Jde v = - 1 / 6 , ~oz dr,/dg t = lira dr,+Jde v = - 1 / 6 .

j~

Again, there are important limiting values of the parameters of model that lead to various approaches to the exchange rate. The key point, however, is that there are shocks which affect the real exchange rate and the nominal rate in similar ways in the short-run. Over time, however, certain shocks will have no effect on the long-run value of the real rate but may have permanent effects on the nominal rate. That is, the model and its variants are all consistent with the notion that nominal shocks can have permanent effects on the nominal exchange rate but only temporary effects on the real exchange rate. The difference between these temporary and permanent effects acts as an identifying restriction that allows us to decompose the two exchange rate series into a component caused by the shock with the temporary impact on the real rate and a component caused by a potentially permanent effect on both the real and nominal rate. We will try to ascertain the extent to which these two shocks can be interpreted as real and nominal shocks. I l L Dynamic effects of real and nominal shocks The variance decompositions under the identifying restriction that B 1 2 ( 1 ) = O in the B M A R allow us to assess the relative contributions of the 'real' and 'nominal' shocks to the real and nominal exchange rate series. As is immediately evident from Table 3, 'real' shocks explain almost all of the forecast error variance of the real exchange rate at any forecast h o r i z o n . 9 This finding is broadly consistent with other papers using the Blanchard and Quah (1989) methodology to decompose movements in the real exchange rate. However, the magnitudes of the contribution of temporary shocks to real exchange rate movements is sometimes smaller than those found elsewhere in the literature. For example, Evans and Lothian (1993) find that, on average, temporary shocks are responsible for 17% and 5.1% of the total variation in the G e r m a n - U S
242

Real and nominal exchange rate movements in the post-Bretton Woods period: W Enders and B-S Lee

TABLE 3. Variance decomposition (percentage of forecast error variance accounted for by real shocks) Model Variable Canada Horizon 1-month 3-month 6-month 12-month 24-month 36-month Germany Horizon 1-month 3-month 6-month 12-month 24-month 36-month Japan Horizon 1-month 3-month 6-month 12-month 24-month 36-month
Ar [Ar, Ae] Ae r [r,e] e

94.9 (1.0) 92.1 (1.2) 91.9 (1.2) 91.9 (1.2) 91.9 (1.2) 91.9 (1.2)

43.9 (0.9) 45.7 (0.9) 45.4 (0.9) 45.4 (0.9) 45.4 (0.9) 45.4 (0.9)

94.9 98.4 99.2 99.6 99.8 99.8

43.9 50.1 47.5 45.9 45.2 44.9

99.9 (1.3) 97.8 (1.7) 97.0 (1.8) 97.0 (1.8) 97.0 (1.8) 97.0 (1.8)

88.4 (1.2) 89.1 (1.2) 87.2 (1.5) 87.1 (1.5) 87.1 (1.5) 87.1 (1.5)

99.9 98.7 99.2 99.6 99.8 99.9

88.4 90.6 86.6 82.2 79.8 79.1

94.5 (1.2) 92.2 (1.6) 91.7 (1.8) 91.7 (1.8) 91.7 (1.8) 91.7 (1.8)

76.3 (1.1) 73.7 (1.4) 73.8 (1.4) 73.8 (1.4) 73.8 (1.4) 73.8 (1.4)

94.5 95.8 98.1 99.1 99.6 t)9.7

76.3 74.3 77.9 80.4 81.6 82.0

Notes: r: real exchange; e: nominal exchange rate; Ar: first difference of real exchange rate; ~e: first difference of nominal exchange rate. The percentage of the forecast error variance explained by the nominal shock is the difference between 100% and the corresponding entry above. The numbers in parentheses are standard errors computed by 1000 simulations.

and the J a p a n e s e - U S real exchange rates, respectively. F o r the U K - U S and I t a l i a n - U S real rates, they find that t e m p o r a r y shocks are responsible for 5.8% and 6.6% of the total variation, respectively. M o r e o v e r , at a 3-month forecasting horizon, Lastrapes (1992) finds that t e m p o r a r y shocks are responsible for 22.2%, 19.7%, 21.5% and 10.4% of the total variation in the G e r m a n , Japanese, Italian and C a n a d i a n bilateral real exchange rates with the US, respectively. Nominal shocks play a larger role in explaining the forecast e r r o r variance of the nominal exchange rate. F o r Canada, G e r m a y and Japan, 'nominal' shocks accounted for no m o r e than 56%, 21% and 27% of the forecast e r r o r variance of nominal exchange rates (or their first difference), respectively. 243

Real and nominal exchange rate movements in the post-Bretton Woods period: W Enders and B-S Lee

Figure 2 shows the impulse response functions of the real and nominal exchange rates to both types of shocks. For clarity, the results are shown for the levels of exchange rates (as opposed to first differences) measured in terms of standard deviations. The important features of the point estimates of the response functions include: 1. For each country, the effect of a 'real' shock is to cause an immediate increase in the real and nominal exchange rate. It is important to note that for each country, the jump in the real value of the dollar is nearly the same as that of the nominal dollar. Moreover, these changes are all of a permanent nature. Real and nominal rates converge to their new long-run levels within a year, and no country exhibits any strong evidence of overshooting. 2. As required by our identification restriction, the effect of a 'nominal' shock on the real exchange rate is temporary and becomes unnoticeable in a few months. Notice that the effects of typical 'nominal' shocks on the nominal exchange rates are significantly smaller than the effects of typical 'real' shocks except for the case of Canada. For Canada, however, a typical
(a)
0.0120. 0.0090 ~ 0.0060 J -0.0030' (b) 0.0085 ,

O.O030J
o.ooool

"1 6

11

16

21

26

31

36

0.0080
0.0O75 "1

0.0070
(c) 0.040

0.0065 'q 0.0060 -

11

16

21

26

31

36

0.030 t 0.020
0.010

/ ~ 1 _-6 1i 16 21 26 31 36

0.000
-0.010 (d) 0.040 0,032 ~ 0.024 -'] 0.016 4

__
1

7,-,
6

...........................
11 16 21 26 31 36

0.008" (e)

0.036 . 0,024 ~

o:Zo 1
(f) 0.035 0.030
0.025 J 0.020 J

11

16

21

26

31

36

o.o151

0.010 -

11

16

21

26

31

36

FIGURE 2. Germany Canadian mark; (e)

Response of real and nominal exchange rate to real and nominal shocks: Canada, and Japan. (a) Response of real Canadian dollar; (b) Response of nominal dollar; (c) Response of real German mark; (d) Response of nominal German Response of real Japanese yen; (f) Response of nominal Japanese yen. - response of real shock; . . . . response to nominal shock.

244

Real and nominal exchange rate movements in the post-Bretton Woods period: W Enders and B-S Lee

nominal shock causes a rise in the nominal value of the US dollar which is similar to that by a typical real shock, although the nominal rate jumps more rapidly in response to real shocks. 3. We can provide additional insight into the effects of the various types of shocks by considering the implied time path of the price ratio (p* - p ) . Recall our previous result that for each country, a 'real' shock induces a jump in the real and nominal rate of nearly the same magnitude. Hence, there is little movement in the price ratio in response to a 'real' shock. Also recall that nominal shocks have no long-run effects on real rates. Since nominal shocks do affect prices, nominal shocks affect prices by an equal but opposite amount. 4. It is instructive to examine the hypothetical time paths of the nominal rates that result from our decompositions) Panel A of Figure 3 shows the decomposition of the Canadian dollar. If all shocks had been real shocks, the Canadian dollar would have depreciated more beginning in 1974 and have appreciated more beginning around 1986. It is particularly interesting to note that the real shock captures the major turning point of actual rates. The sharp appreciation beginning around 1986 is the result of real, as opposed to nominal, factors. 5. As depicted in Panel B of Figure 3, the situation is somewhat different for Germany. Again, the real shock captures the major turning points of actual rates so that real shocks were responsible for the sustained appreciation of the dollar (above its mid-1970's level) through 1985 followed by the subsequent decline. However, the mark-dollar rate would have remained relatively higher up until 1984 had there been only real shocks. As shown by Panel C of Figure 3, had there been only real shocks, the dollar would have

(a) 1.44

73 (b) 3.5 2.8 2.1 1.4

t ~

76

79

82

85

88

91

tt~

x~j

~ x

~ . 73 . . . 76 . . 79 . . . 82 . . 85

~ . , , ~ . . 88 91

(c)
32O 280 240 2OO 160 120 73 76 79 82 85 88 91

FIGURE 3. Decomposition of nominal exchange rates. (a) Decomposition of Canadian dollar; (b) Decomposition of German mark; (c) Decomposition of Japanese yen. - actual size; . . . . real component (series due to real shocks). 245

Real and nominal exchange rate movements in the post-Bretton Woods period: W Enders and B-S Lee TABLE 4. Test o f over-identifying restrictions

Bivariate M A R :

Ae,I=LB2,<L
Bivariate V A R :

B22<L ]['2,l'
l [""l

e,J [Az,(L) Azz(L)JLe,_,j+[u2,] '

where A i j ( L ) = aij,1 + aij,zL + aij,3 L2. T h e over-identifying restriction: /40: B22(L)IL= 1 -= B22(1)= 1, or equivalently /40:A21(1)B(0)12 + (1 -AI1(1))B(0)22

= (1 - A it(1))(1 - A 22(1)) - A 12(1)A 21(1) (i) Canadian dollar:

X 2 (1) = 34.5116; significance level = 0.000 (ii) G e r m a n mark: X 2 (1) = 3.0919; significance level = 0.0787

(iii) Japanese yen:

X 2 ( 1 ) = 7.7329; significance level = 0.0054 A t h i r d - o r d e r V A R r e p r e s e n t a t i o n o f A r t a n d A e t was e s t i m a t e d for the 1973:5-1992:4 sample period.

remained less strong relative to the yen during the mid-1970s. Since 1978, the role of nominal shocks in the Japanese yen becomes negligible. 6. It is possible to test the overidentifying restriction suggested by equation (18). Imposing the restriction B22(1)= 1 is equivalent to restricting the nominal shock to have a proportional effect on the nominal exchange rate in the long-run. As reported in Table 4, at conventional significance levels this test is rejected for each country. Since B22(1) is a l w a y s positive, it is possible to conclude that a positive nominal shock causes domestic currency depreciation but that the long-run effect is not proportional. One possible explanation that is consistent with our illustrative model is that nominal shocks do not have a proportional effect on the money supply. 11 As such, nominal shocks will not have a proportional effect on the nominal exchange rate. Another possible explanation is that the nominal disturbance represents a reduction in money demand as opposed to a change in money supply.
246

Real and nominal exchange rate movements in the post-Bretton Woods period: W Enders and B-S Lee

IV. A re-interpretation of the structural models

In using a 'small' country model to explain the US data, it is necessary to reinterpret the variables of the models as referring to relative magnitude. As suggested above for considering the case of two 'large' countries, we let m,, g , , and Yt denote the U S / f o r e i g n money supply, the level of aggregate demand (possibly government spending), and level of real income in period t. The dynamic effects are only loosely in accord with the structural models of exchange rate determination. Nominal shocks never explain more than 8.3% of real exchange rate movements and have a limited role for explaining nominal exchange rates. The primary effect of nominal shocks is on price levels. Moreover, there is little evidence supportive of exchange rate overshooting. For both Canada and Germany, the impulse response function of the nominal exchange rate to nominal shocks shows a rather steady approach towards its long-run level in about 6 months. For Japan, the nominal rate jumps almost immediately to the long-run level. Real shocks, on the other hand, seem to play an important role in explaining both real and nominal exchange rate movements. In response to real shocks, real rates appear to jump to their long-run levels. Nominal rates also display a large jump in response to real shocks. It is important to note that the magnitude of the real and nominal exchange rate movements in response to real shocks are virtually identical. It seems reasonable to try to re-interpret the structural models in light of the econometric evidence. The finding that real rates jump to their long-run level almost instantaneously and are virtually unaffected by nominal shocks is consistent with a very large value of rr. In reformulating the Dornbusch model, we let ~r ~ oo; the implication is that prices adjust to clear the goods market instantaneously. The goods market equation can be rewritten as: (11') Yt = (1 - ~-)-l[6(et
-p~) +g, - ~rEt(et+ l -

e,)].

For the German and Japanese cases, nominal shocks had relatively little effect on the nominal exchange rate. For Canada, nominal shocks did have a role, although small, in affecting the nominal exchange rate. In trying to reconcile these findings with the structural models, it is tempting to argue that the variance of the nominal shock must be small relative to the variance of the real shock. If we re-interpret shocks to refer to relative magnitudes, the variance of each nation's money supply could be large, while the variance of the ratio could be quite small. Since prices do respond to nominal shocks, it is not appropriate to consider a limiting case in which Var(%~)= 0. Overall, these findings are very hard to reconcile with any model assuming PPP. However, if 6 is finite in equation (11'), prices and nominal exchange rates have different response functions to real shocks. Given the money market equilibrium condition in equation (9), if real shocks are primarily demand-side shocks, one would expect prices to be affected primarily by nominal shocks and nominal rates to be affected primarily by real shocks. There is additional support for the view that 6 is finite and that real shocks are primarily of the demand-side variety. Given the non-stationary behavior of
247

Real and nominal exchange rate movements in the post-Bretton Woods period: W Enders and B-S Lee

real exchange rates during the post-Bretton Woods period, there is little point in assuming purchasing power parity holds; thus, we can assume a finite value of 3. Notice also that the shape and magnitudes of the time paths of real and nominal exchange rates in response to a real shock match closely. From equations (15) and (16), it is seen that a Yt shock has differential effects on the two rates but that a gt shock affects the two rates equally. This result is consistent with the findings of Lastrapes (1992), and Ahmed et al. (1993). For example, using the Blanchard and Quah (1989) technique, A h m e d et al. (1993) find that only a demand shock has a significant long-run effect on the relative price of US imports. However, they attribute the demand shock to a preference shock, as opposed to a fiscal shock. Unfortunately, there is a major difficulty in the identification of the modelas presented. As indicated above, in a 2 2 model, it is possible to identify only two different types of shocks. As such, we cannot formally identify the real shocks as a supply side shock, or a demand side shock such as a change in government expenditures or preference. To gain additional insight into the relative importance of demand-side versus supply-side shocks, we collected the values of real government expenditures, real GNP, and the nominal money supply (as measured by M1) for each of the four countries in our study. To proxy real demand-side shocks (gt), real supply-side shocks (Yt), and nominal shocks (rnt), we use the logarithm of US to foreign real government expenditures, real GNP levels, and nominal money supplies, respectively. Although we have a healthy skepticism of any structural interpretation placed on the results of a V A R analysis, it is of interest to assess the relative importance of the various shocks in a V A R context. Our analysis implies that m t should not help in explaining the forecast error variance of the real component of the decomposed exchange rate (rPt). Moreover, the relative importance of demand-side versus supply-side shocks might be inferred from a variance decomposition of rPt. Since National Income and Product Account data is quarterly, we used every third month of the rp, series in the VAR. Table 5 reports the variance decomposition of the rpt sequence for Canada, Japan and Germany. Notice that our decomposition orders the innovations such that Yt precedes gt, which precedes rpt. This ordering may bias the results towards increasing the relative importance of the supply-side shock. 12 Notice that for very short horizons, the real component explains almost all of its own forecast error variance. However, government expenditure innovations explain a reasonably large proportion of the forecast error variance of the real component at longer horizons. Respectively, government expenditure shocks explain over 65%, 20% and 25% of the 12-step ahead forecast error variance of the US-Canadian, U S - G e r m a n and US-Japanese real component. In contrast, real income shocks never explain as much as 9.4% of the forecast error variance of any real component. It is also noted that money supply shocks never explain as much as 4% of the forecast error variance of any real component at any forecasting horizon. Reversing the ordering does not affect this result. Granger-causality tests indicate that lagged values of the money supply do not aid in forecasting any of the real component at conventional significance levels.
248

Real and nominal exchange rate movements in the post-Bretton Woods period: W Enders and B-S Lee

TABLE5. Variance decomposition of the real component (rPt) of exchange rates: percentage of forecast error variance accounted for by shocks in national income (y), government expenditure (g), and money supply (m) Shocks in Variable Canada Horizon (quarter) 1 2 4 8 12 Germany Horizon (quarter) 1 2 4 8 12 Japan Horizon (quarter) 1 2 4 8 12 y g rn q~

3.3 (2.0) 2.2 (2.0) 1.0 (2.0) 0.6 (2.1) 0.4 (2.1)

0.0 (2.0) 3.7 (2.0) 20.1 (1.8) 50.7 (1.5) 65.2 (1.3)

0.0 (1.7) 0.7 (1.6) 0.9 (1.4) 1.0 (0.8) 0.9 (0.6)

96.7 (0.9) 93.4 (0.9) 77.8 (0.7) 47.7 (0.4) 33.4 (0.3)

1.5 (0.0) 0.8 (1.9) 0.4 (1.9) 2.0 (1.9) 9.4 (1.8)

0.0 (1.9) 0.0 (1.9) 2.0 (1.9) 11.7 (1.8) 20.7 (1.6)

1.0 (1.8) 1.8 (1.8) 1.1 (1.8) 0.9 (1.5) 0.7 (1.2)

97.5 (0.9) 97.4 (0.9) 96.5 (0.9) 85.4 (0.8) 69.2 (0.7)

0.0 (2.1) 0.1 (2.1) 0.2 (2.1) 3.1 (2.0) 7.2 (2.0)

2.3 (1.8) 6.8 (1.8) 14.0 (1.7) 23.3 (1.6) 25.7 (1.5)

3.7 (1.8) 4.8 (1.7) 4.0 (1.7) 3.9 (1.4) 3.8 (1.2)

93.9 (0.9) 88.3 (0.8) 81.7 (0.8) 69.8 (0.6) 63.4 (0.6)

Notes: y: the logarithm of US to foreign real GNP levels; g: the logarithm of US to foreign real government expenditures; m: the logarithm of US to foreign money (M1) supplies; rp: exchange rate due to real shocks (i.e. real component). The numbers in parentheses are standard errors computed by 1000 simulations.

Figure 4 shows the share of US federal government spending in G N P for the post-Bretton Woods period. Of course, US bilateral exchange rates respond on both foreign and domestic shocks; no single shock can be reasonably expected to explain all exchange rate movements. O n examining the hypothetical time paths of exchange rates for the case in which only real shocks occur (Figure 3), it is interesting to note that the major turning points for Japan, G e r m a n y and to a lesser extent, C a n a d a roughly correspond to those in Figure 4. US government expenditure share along with the decomposed yen and mark series reversed their earlier decline in 1979-1980 and then rose through 1984. Particularly important is the fact that the share of US federal government expenditures began to decline in 1986-1987; this is about the time at which the exchange rate series started their fall. Blanchard and Q u a h (1989) prove several propositions that lead us to believe 249

Real and nominal exchange rate movements in the post-Bretton Woods period: W Enders and B-S Lee

8.5

8,0

73

7.0

73

76

79

82

8s

88

91

FIGURE4. US federal government spending as a percentage of GNP.

that our classification of shocks into two types (real versus nominal) may provide a meaningful decomposition. Suppose, as we assumed in our presentation of the Dornbusch (1976) model, that there are several types of real disturbances but only one nominal disturbance. If the variance of one type of real disturbance grows 'arbitrarily' small relative to the other, then the decomposition scheme used here approaches the correct decomposition. Intuitively, in terms of the model above, if the variance of either ~gt or ~yt approaches zero, our decomposition approaches the true decomposition. Note that in terms of our V A R results, the ratio of the variance in the real supply shock to the variance in the government expenditure shock is given in Table 6. Hence the variance of the innovation in government expenditures is sizably larger than that for real output. 13 They also prove a second proposition which can render our decomposition meaningful. Specifically, if there are multiple real disturbances (nominal disturbances), correct decomposition is possible if and only if the individual distributed lag responses in the real and nominal exchange rate are sufficiently similar across equations. By 'sufficiently similar', Blanchard and Quah mean that the coefficients may differ up to a scalar lag distribution. 14 The meaning of their theorem can be interpreted in terms of equations (15)
TABLE 6. Variance ratio var(ey)/(var(eg) Canada
0.161

Germany 0.398

Japan 0.256

250

Real and nominal exchange rate movements in the post-Bretton Woods period: W Enders and B-S Lee

However, the effects of the output shock are such that the contemporaneous effects are identical across equations but the lagged coefficients differ by the scalar /3o/(/30 - 1). If the contemporaneous effects of the output shock are small (i.e. /32 is appropriately small) or if ~r is appropriately large so that all adjustment happens without any lags, then our decomposition may be useful. However, as argued above, since overshooting is not observed, it seems reasonable to presume ~- is large. Our casual empiricism is only intended to be suggestive of a possible candidate for the real demand-side 'fundamental' determinant of exchange rates. In fact, the advantage of our non-structural approach to exchange rate movements is that we avoid many of the measurement problems inherent in estimating a structural model. We do not need to determine whether M1 or M2 is the 'right' measure of the money supply or whether gt versus the government's deficit is the 'best' measure of the fiscal shock. The difficulties are magnified since the estimation necessitates incorporating both domestic and foreign country variables. However, others have suggested an important role for demand-side shocks using more traditional methods. Koenig (1989) argues that, in addition to real supply factors, investment demand has had a major influence on exhange rates; Worthington (1991) finds a strong correlation between real exchange rates and investment that can be interpreted as the effect of investment demand on exchange rates. ~5 Backus (1986) estimates a V A R model including the US-Canadian exchange rate and relative price level. Both real demand-side and supply-side variables are found to have important effects at medium and long-term forecasting horizons.
V. Conclusions

We have used the technique developed by Blanchard and Quah (1989) to decompose real and nominal exchange rate movements into the components induced by real and nominal factors. Our so-called 'real' shock explains the preponderance of real and nominal exchange rate movements. We provide some informal evidence in Section IV that suggests the real shock can be identified as an aggregate demand shock. In particular, there is indirect evidence that government spending shocks have been an important source of exchange rate movements during the post-Bretton Woods period. These results have some important implications for recent time series tests of exchange rate models. For the low inflation nations considered here, nominal shocks appear to have had little role in inducing exchange rate movements. Of course, monetary shocks can potentially affect exchange rates for high inflation countries. ~6 However, for the industrial nations, our results suggest that such nominal shocks (e.g. relative money supply changes) have been small. Morevover, tests of structural exchange rate models typically identify income levels, money supplies, and interest rates as the critical 'fundamentals' responsible for exchange rate changes. We find that aggregate demand shocks are responsible for the preponderance of exchange rate movements. It follows that tests of exchange rate models which ignore aggregate demand factors are likely to have poor out of sample forecasts. The natural
251

Real and nominal exchange rate movements in the post-Bretton Woods period: W Enders and B-S Lee

extension of our research is to appropriately incorporate real demand-side factors into the theory of exchange rate determination; the resulting structural model should explain recent exchange movements more satisfactorily than the existing models.
Notes
1. For example, MacDonald and Taylor (1993, 1994) show that it is possible to impose the long-run monetary restrictions in a dynamic cointegration framework. The resulting model leads to exchange rate forecasts superior to those generated by a random walk model. We obtained monthly wholesale price indices and nominal exchange ratesfrom the IMF data tapes over the period from January 1973 through April 1992 period. In the paper, we express nominal rates as the US dollar price of foreign currency. Real rates were constructed, as indicated by equation (13), from the product of the foreign price level and nominal exchange rate divided by the US price level. Since we normalized price levels at unity in January 1973, real and nominal rates are necessarily equal in January 1973. Below, we pay serious attention to the possibility that there may be more than two important sources of variability. In Section II, we deliberately develop a model with three types of shocks (one nominal shock and two types of real shocks) in order to consider the identification problems entailed. Quah (1992) shows that there is such a decomposition. He shows how to construct such a decomposition in which one component is a permanent, the other is temporary, and the innovations in the two components are uncorrelated at all lags and leads. All three real and nominal rates exhibit periods of sustained increases and periods of sustained declines. As such, we included a dummy variable in estimation of the BVAR to incorporate a break around 1985. As in Blanchard and Quah (1989), when we allowed for a change in the exchange rate movements, we simply removed the different sample means before estimating the differenced V A R system. The dummy trend variable appears to be quite significant and improves the fit of the V A R model. For details, see Blanchard and Quah (1989). Lee (1995, 1996) shows that a present value relationship gives rise to the restriction B12(1) = 0 in a BMAR framework. From z t = ~ = o b ( s ) e~_~, the t-step ahead forecast of z, based on z0, z 1, z 2.... is given by E [ z t l z o, z_ I, z 2,---] = Y"s=t b(s)Et ,. The t-step ahead forecast error, say w t, is given by
t-I

2.

3.

4, 5.

6. 7.

w t = - z t - E [ z t l z o , z 1, z-2,...] = ~
s= 0

b(s)et

,.

Thus t-step ahead forecast error variance is given by

It
Ls=O

1
'

t-I
s=o

]
'J

t-I
s=O

E [ w t Wr'] = EJ Y'. b ( s ) E t ~, ~., b ( s ) e t ~]' = Y'. trace b ( s ) b ( s ) ' .

Then, t-step ahead forecast error variance in zi, which is accounted for by innovations in z j, is
t-I
s=l}

2
j=l

t-I
s=l)

E bij(s)2//E E bij(s)2.
8.

The unitary income elasticity of money demand is assumed for expositional convenience only; it has no bearing on our findings.

252

Real and nominal exchange rate movements in the post-Bretton Woodsperiod: W Enders and B-S Lee

9.

10.

11. 12. 13. 14. 15. 16.

The standard errors in Tables 3 and 5 are obtained by using the procedure in RATS, which is based on a Monte Carlo integration due to Kloek and Van Dijk (1978). The Monte Carlo results are based on 1000 simulations and take into account the identifying restrictions. For visual clarity, the time paths of the decompositions are presented in levels, rather than in first-differences; units are the foreign currency price of the US dollar. We do not present the decompositions for real rates; movements in real rates were found to be caused by real shocks only. For example, if e,,,t + i is represented by emt+l p emt + Vt+ 1 with I p[ < 1, then a pure nominal shock vt+ 1 will not have a proportional effect on the money supply. By using Akaike information criterion, two lags were used. The results in Table 5 are not sensitive to the changes in the ordering of the variables. We do not provide a formal test of whether var(ey)/var(eg) is significantly different from zero. There is no formal test of the equality of coefficients of the demand and supply shocks. Note that Throop (1989) contends that US government expenditures explain exchange rate movements through 1985. We also examined the real and nominal rates for Argentina and Brazil. We found that nominal disturbances appeared to dominate the time path of both real and nominal rates.
=

References
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Real and nominal exchange rate movements in the post-Bretton Woods period: W Enders and B-S Lee

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254