Three Essays on Real Exchange Rates


Student thesis: Doctoral Thesis

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Award date8 Aug 2019


This thesis comprises three empirical essays on the determinants of real exchange rates.

The first essay studies the determinants of the relative price of nontraded-to-traded goods, which is a key relative price for an open economy and distinguishes the role of real income per capita among supply- and demand-oriented theories. While the conventional supply-side models such as the Balassa-Samuelson model and the Heckscher-Ohlin model have been extensively studied in the literature, the effect of income on relative prices via the demand-side – the so-called Linder hypothesis -- has not been studied extensively.

Using a rich sectoral dataset of 39 countries with heterogeneous income levels from 1976-2009, we study the determinants of the relative price of nontraded-to-traded goods in a panel cointegration framework. In addition to the conventional supply-side effects, we identify a significant income-effect which operates via the demand channel, thereby confirming the Linder-hypothesis. We also classify countries into low, medium and high-income groups and verify the robustness of the Linder-hypothesis at different stages of development.

Do prolonged terrorist activities and government efforts to curb them affect domestic and international relative prices? The second essay attempts to answer these questions in the context of Pakistan’s economy. Using real terrorism expenditures, real military expenditures and real US aid as potential proxies for terrorism, we examine the link between terrorism, the relative price of nontradables and the real exchange rate. We use the sectoral data of Pakistan and United States to construct relative prices, bilateral real exchange rate and productivity differentials. Controlling for other structural determinants such as productivity-differentials, we find that campaigned terrorism is cointegrated with both the relative price of nontradables and the bilateral real exchange rate. Our results are consistent with the view that the war on terrorism declared by the government of Pakistan resulted in an increase in government spending to compensate the families of the victims of terrorism, for reconstruction of destroyed infrastructure, and to counter terrorist activities. This increase in government spending fell disproportionately on nontradables, thereby increasing the relative price of nontradables and causing a real appreciation.

The third essay explores the role of infrastructure investment on the real exchange rate. Utilizing 4 different measures of the real exchange rate and 2 large panel datasets, and using a panel cointegration framework, we uncover a robust positive and economically significant long-run relationship between infrastructure investment and the real exchange rate. When we classify our panel into developing- and developed subpanels, we find that Balassa-Samuelson effect is statistically insignificant in the developed panel, but the infrastructure investment effect is significant and almost equal in magnitude between developing and developed panels. We conclude that infrastructure investment effect is a key explanatory variable for understanding real exchange rate movements regardless of the level of development of a country.