ABSTRACT
In this chapter we move away from the long-run exchange rate framework provided by PPP and the monetary model to a more eclectic exchange rate model, which combines both real and nominal factors. In particular, we have seen from our discussion of the recent literature on PPP that it takes about 8 years for a deviation from PPP to be extinguished. As we noted in Chapter 3, part of the explanation for this slow mean reversion might lie in the existence of transportation costs which introduce non-linear thresholds. An alternative explanation is that there may be ‘real’ factors (one of these being the Balassa–Samuelson effect, considered in Chapter 2) which introduce systematic variability into the behaviour of real and nominal exchange rates and in this chapter we examine some recent work which seeks to model this systematic variability. Also considered in this chapter are a number of other issues relating to real exchange rates such as real exchange rate volatility and real interest rate parity.
