Friday, February 27, 2009

Exchange rates - goods or assets?

The NBER looks at the issue of exchange rates and prices. Betts and Kehoe find that the ratio of tradable to non-tradable prices are affected by nominal exchange rates. However,

When the authors include China, for which the data is annual rather than quarterly and only dates back to 1985, the results change very little. But for the United States and its European trading partners, the relationship is dramatically weaker. Fluctuations in the relative price of non-traded-to-traded-goods account for only 7 percent of the fluctuations in the bilateral U.S./EU real exchange rates when measured in four-year differences using a variance decomposition. By contrast, these relative price fluctuations account for 29 percent of the fluctuations in U.S./non-EU real exchange rates and 39 percent of the fluctuations in U.S./Canada and U.S./Mexico real exchange rates. The authors suggest that the lower ratio for the United States and the EU nations may be attributable to the relatively low importance of trade, compared to the size of these economies. They note that just because there's a relationship between exchange rates and domestic prices, it does not follow tha! t one drives the other.

This provides further evidence that it is the capital flows that dominate the exchange rate trading.

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