The real exchange rate (RER) puzzle has spawned an extensive literature, stimulating researchers to propose different explanations [Rogoff, 1996; Betts and Devereux, 1996; Hau, 2000; Obstfeld and Rogoff, 2001; Bergin and Feenstra, 2001; Chari, Kehoe, and McGrattan, 2002; Devereux and Engel, 2002; Morshed and Turnovsky, 2004; Chen and Hsu, 2009; Carvalho and Nechio, 2010]. Two key aspects of the puzzle are: (i) the long-term persistence of the real exchange rate following a structural change, and (ii) its short-term volatility, both of which exhibit systematic patterns across economies. With respect to the persistence of the real exchange rate, the rate of convergence to its long-run equilibrium value is significantly slower for developed countries than it is for developing countries [Cheung and Lai, 2000].
These authors examined a number of structural characteristics such as inflation, productivity growth, trade openness, and the size of government spending to account for these cross-country differences in the rate of convergence. They observe that only inflation and government spending yield a weak relationship with the observed pattern of persistence. Consequently, their findings underscore the need to identify the determinants of the persistence of the PPP deviation in order to explain these differences. With regard to volatility, Hausmann, Panizza, and Rigobon (2006) show that developing countries have substantially more volatile real exchange rates than do developed countries, a difference that cannot be explained by differences in the magnitudes of the underlying shocks. In addition, Hau (2002) finds that increased openness is associated with less volatility in the real exchange rate.
A natural framework for addressing the dynamics of the real exchange rate is the dynamic “dependent economy model”, which determines the real exchange rate within a two-sector production framework. But if one employs the standard Heckscher-Ohlin production structure, in which the aggregate labor supply is fixed and the productive factors are perfectly mobile across sectors, the model is unable to generate plausible real exchange rate dynamics. Depending upon relative sectoral capital intensities, the real exchange rate adjusts too rapidly or even worse, instantaneously.
To generate realistic exchange rate dynamics some source of sluggishness must be introduced into the adjustment process. Steigum and Thørgesen (2003) and Morshed and Turnovsky (2004) do so by relaxing the conventional assumption that capital can be instantaneously and costlessly shipped across sectors. Instead, they assume that the intersectoral movement of capital involves adjustment costs, reflecting the costs of retrofitting, an idea that can be traced back to Mussa (1978) and later to Gavin (1990, 1992).
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Real Exchange Rate Dynamics: The Role of Elastic Labor Supply
