Persistence and volatility of real exchange rates: the role of supply shocks revisited
This paper re-examines the role of supply shocks for real exchange rate fluctuations. First, in a structural VAR analysis, we combine long run and sign restrictions to identify productivity and non-productivity supply shocks. Second, we show that a variance decomposition in the frequency domain generates quantitatively different results compared to the standard forecast error variance decomposition. In particular, productivity shocks are the most important driver of US real effective exchange rate fluctuations at low frequencies, while real demand shocks are more salient at high frequencies. We use the spectrum at frequency zero to structurally decompose the persistence of the real exchange rate. Supply shocks explain more than half of the persistence of the exchange rate.