Revisiting the Long-Run Relationship between Real Exchange Rates and Real Interest Differentials: A Productivity Differential Approach Patterns in Neighboring Areas

This paper presents some evidence that long-run modeling of real exchange rates should take into account both monetary and real factors. In particular, we show that long-run movements of the dollar-yen and dollar-mark real exchange rates are well described by a cointegrating relationship which includes both real interest differentials and productivity differentials. The former account for the extremely long-lived deviations of real exchange rates from their equilibrium level, which appears to be determined by the latter. Therefore, ‘sticky price’ open macro models are missing an important variable, i.e. the stochastic trend corresponding to the productivity differential. The results are robust to employing alternative unit root and cointegration testing methods, as well as estimation procedures. Empirical modeling requires treating real interest differentials as I(1) series, even though they are likely to be a near-unit root (or fractionally integrated) process.