Explaining long term exchange rate behavior in the United States and Japan

Anwar Shaikh
Professor of Economics
Department of Economics, Graduate Faculty
New School for Social Research
6 E. 16th Street, Room 1124
New York, NY 10003
email: shaikh@newschool.edu
homepage: http://homepage.newschool.edu/~AShaikh/
Rania Antonopoulos
Director of the Gender Equality and the Economy Program
Levy Economics Institute of Bard College
Annandale-on-Hudson NY US 12504-5000
email: rania@levy.org

A practical knowledge of exchange rates is of vital importance for economic policy in our increasingly interconnected world. The difficulty is that the current models of the exchange rate perform quite poorly at an empirical level. This makes them an unreliable guide to economic policy. Conversely, in order to have a sound foundation for economic policy, one should operate from a theoretically grounded explanation of exchange rates which works well across a spectrum of developed and developing countries. The present paper extends the theoretical and empirical foundation developed in Shaikh (1980, 1991, 1995), previously applied to Spain, Mexico and Greece (Roman 1997, Ruiz-Napoles 1996, Antonopoulos 1997), to the explanation of the exchange rates of the United States and Japan. Conventional exchange rate models are based on the fundamental hypothesis that, in the long run, real exchange rates will move in such a way as to make countries equally competitive. Thus they assume that in the long run trade between countries will be roughly balanced. In contrast, our framework implies that it is a country’s competitive position, as measured by the real unit costs of its tradables, which determines its real exchange rate. This determination of real exchange rates through real unit costs allows
one to explain why trade imbalances remain persistent. It also provides one with a policy rule-of-thumb for sustainable exchange rates. The aim is to show that one can construct a theoretically grounded, empirically robust, explanation of real exchange rate movements which can be of practical use to researchers and policy makers.

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