How Important are Nominal Shocks in Driving Real Exchange Rates?

Most of the extant literature identifies the sources of real exchange rate fluctuations by means of structural VAR analysis using long-run identification restrictions only. This paper presents an analogous decompositon on the basis of a simple textbook model of exchange rate determination, where identification is achieved after a suitable triangularization. This identification strategy allows for a calibration on the basis of the contemporaneous restrictions implied by the model. In order to facilitate a comparison with the results form the structural VAR stuies, very similar data are used here as well. These ar quarterly data collected on the bilateral exchange rates for the Deutsche Mark, the British Pound and the Japanese Yen, all relative to the U.S. Dollar. The implied impulse response functions of the model exhibit impact reactions of the exchange rate following either a monetary (nominal) or a real shock, thus conforming to the asset price property of exchange rates. This is in contrast to the delayed exchange rate responses typical in the structural VAR studies. Moreover, The variance decompositions indicate a dominant role for real shocks, with nominal shocks recognizable at best only in the short run. These results correspond quite closely to those obtained from structural VARs.