The Causes of Real Exchange Rate Variability: A Heretic View from the Interwar Period

Historically, real exchange rate variability has been higher under flexible than under fixed exchange rates. Two explanations have been put forward. The neo-Keynesian view focuses on the interaction of volatile nominal exchange rates with sticky prices. The neoclassical approach maintains the flexible price assumption and regards an increased incidence of real shocks as the culprit. Using spectral decomposition, we examine the evidence on sticky prices for the interwar period. Prices and exchange rates are found to be equally flexible, contrary to the sticky price view and consistent with the instantaneous equilibrium approach.