Economic Fluctuations In The Real Exchange Rate Changes

The article starts with the question whether there is a certain relationship between business cycles and real exchange rate fluctuations. A brief review of the economic development after WWII and exchange rate arrangements of several main international currencies shows that simple and everlasting connections can NOT always be found in economic history.As business cycle theory fails to explain the extra volatility of exchange rates comparing to output and other main economic indicators, the article turns to theory of real exchange rate determination. PPP theory is where all open economic models start and the foundation of our analysis. Economists have experienced three stages in testing the theory of PPP, namely the simple testing of relative PPP, testing real exchange rate as a random walk and the recently prevailing co-integration test.All the empirical tests tend to reach one upsetting conclusion that PPP has less data supporting than we expected. So the Isald model and the Border model try to find the reason why PPP theory is violated, the Balassa-Samulson model gives a unique explanation from changes in relative price of traded and untraded goods. The article modifies this model a little bit by taking into consideration the demand factors, which is lacking from the origin model, and develops a simple open macroeconomic model.The stochastic form of the model is used to test datacollected from Japan and other G7 countries. Relative real output, real effective exchange rate and relative price levels are filtered and run through unit root tests and co-integration test to show the preliminary relationships. Then, the article sets up a vector auto-regression (VAR) model with the three just mentioned variables in the log form. By setting long-term restrictions advanced by Blanchard and Quah, the model is identified to show, by using impulse response analysis, variance decomposition and historical decomposition, effects of three orthogonal structural shocks: real demand shock, real supply shock and nominal shock.Finally, the article turns to the fluctuation of Chinese economy and effects of deferent shocks on the changes of real effective exchange rate of RMB. Since analysis shows that RMB will be appreciating in the long run, the article ends with several policy suggestions on how to boost China's export.