Real Exchange Rates and the Relative Prices of Non-Traded and Traded Goods: An Empirical Analysis

Bank of England Working Paper No. 223

44 Pages Posted: 4 Jan 2005

See all articles by Jan J. Groen

Jan J. Groen

Federal Reserve Bank of New York

Clare Lombardelli

Bank of England - Monetary Analysis

Date Written: June 2004

Abstract

This paper provides an empirical analysis of the decomposition of UK real exchange rates into the relative price of traded goods and the ratio of the relative price of non-traded to traded goods, and tests the prediction that deviations from the law of one price in tradable goods dominate real exchange rate variability only in the short run. UK bilateral real exchange rates are examined relative to a sample of six main OECD partners. The existence of a long-run relationship between real exchange rates and these corresponding relative price ratios is analysed using cointegrated vector autoregressive models. These show only limited evidence of a cointegrating relationship. The paper quantifies the severity of the deviations from the law of one price, and shows that these deviations are persistent relative to the length of the sample period. This motivates the use of a multi-country panel cointegration-testing framework, which produces evidence of a long-run relationship between the real exchange rate and the non-tradable component.

Keywords: Real exchange rates, Balassa-Samuelson, half-life measures, (panel) cointegration

JEL Classification: C32, F30, F31, F47

Suggested Citation

Groen, Jan J. and Lombardelli, Clare, Real Exchange Rates and the Relative Prices of Non-Traded and Traded Goods: An Empirical Analysis (June 2004). Bank of England Working Paper No. 223, Available at SSRN: https://ssrn.com/abstract=641242 or http://dx.doi.org/10.2139/ssrn.641242

Jan J. Groen (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

HOME PAGE: http://nyfedeconomists.org/groen/

Clare Lombardelli

Bank of England - Monetary Analysis ( email )

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