Piecing the puzzle : real exchange rates and long-run fundamentals

Abstract

This paper examines the structural determinants of real exchange rates, emphasizing the persistent low-frequency movements that traditional models, such as Purchasing Power Parity (PPP) and Uncovered Interest Parity (UIP), often fail to capture. To address this, we propose a structural VAR model with common trends, enabling a clear distinction between transitory and long-term effects of structural shocks. Estimated using Bayesian techniques and applied to Canada and Norway — two resourcerich economies — the model reveals that productivity shifts and commodity market trends significantly influence domestic activity and the real exchange rate in both countries. Importantly, the model also avoids the delayed overshooting puzzle commonly associated with recursive VARs in response to monetary policy shocks. Instead, it generates exchange rate dynamics consistent with the UIP hypothesis, characterized by immediate overshooting followed by a gradual depreciation to equilibrium.