Global and country-specific factors in real effective exchange rates

Using the Bayesian factor model, we decompose movements in real effective exchange rates, which can be considered a measure of external competitiveness, into global and country-specific factors. In data from a number of developed and developing countries, we find a particular global trend in these rates, but a substantial proportion of the variation in these rates is found to be country-specific. In addition, consistent with economic theory, this global factor is closely related to a trend in the global interest rate, while country-specific factors to idiosyncratic movements in countries’ own interest rates.