Private Consumption, Nontraded Goods and Real Exchange Rate: A Cointegration_Euler Equation Approach

Abstract

This paper presents an empirical study of real exchange rate movements from a consumer's perspective. Trade between two countries creates a link between real exchange rate and terms of trade. It is the private consumption of non-traded goods that induces an equilibrium relationship between real exchange rate and private consumption of traded and non-traded goods. We use Ogaki and Park's (1989) cointegration-Euler equation approach to explore long-run implications from the equilibrium relationship. Given the stationary preference shocks assumption, the testable restriction is that real exchange rate and private consumption of traded and non-traded goods in the home and foreign countries are cointegrated. The empirical evidence suggests that private consumption in the home and foreign countries accounts for a significant fraction of the long run movements of real exchange rate in South Korea and Taiwan. Accounting for real government consumption does not overturn the result.

Trade Liberalization, Consumption, and Real Exchange Rate in Seven ASEAN+6 Countries

“…Empirical finding on the relationship of consumption and RER indicates significantly that increasing consumption induces appreciating RER, which is in contrast with Devereux & Hnatkovska (2011). Different with Lin (1996), this study shows consumption is a significant variable affecting real exchange rate. The finding of this study is in line with the literature theory in Mankiw (2012) and contrary with Ravn (2012).…”

“…This relationship finding is in contrast with Devereux & Hnatkovska (2011). The significant relationship result is also contrary with Lin (1996) which shows that consumption is not a fundamental exogenous variable. Theoritically, the finding of my study is in line with the literature theory in Mankiw (2012) and contrary with Ravn (2012).…”

“… 3) Theoritically, consumption may lead to appreciating RER (Mankiw, 2012) or depreciating RER (Ravn, 2012). Empirically, increased consumption will lead to depreciating real exchange rate and vice versa (see Devereux and Hnatkovska, 2011), although according to Lin (1996) consumption is not a fundamental exogenous variable.…”

“…Their argument is in contrary with basic prediction of efficient risk-sharing -relative consumption growth rates across countries or regions should be positively related to real exchange rate growth rates across the same areas. While Lin (1996) found that although household consumption is a significant element in explaining the long run movement of real exchange rate in South Korea and Taiwan, this variable is likely not a reliable fundamental affecting real exchange rate and thus should be combined with other variables on the supply side.…”

“…The relationship of trade liberalization and real exchange rate may be found in Edwards (1987a;1987b;1987c), Tokarick (1995), Mendoza (1995), Head and Ries (1999), Jimoh (2006), Insaidoo and Screwdriver (2008), Zakaria and Ghauri (2011), and Ju-Ai Ng (2013). Furthermore, the answer to the relationship of macroeconomic variables and real exchange rate has been discussed in several studies such as Devereux and Hnatkovska (2011), Edwards (1987b), Lin (1996), Mussa (1984), Obstfeld (1984), Ravn, Schmitt-Grohe, Uribe (2007), and Ravn, Schmitt-Grohe, Uribe (2012).…”