DP209 Determinants of the Equilibrium Real Exchange Rate

Author(s): J Peter Neary
Publication Date: December 1987
Keyword(s): Dutch Disease, Foreign Aid, Open Economy, Purchasing Power Parity, Real Exchange Rates
JEL(s): 411, 431
Programme Areas: International Trade and Regional Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=209

This paper presents a compact derivation of the determinants of changes in the equilibrium real exchange rate (the price index of non-traded goods relative to traded goods) in a small open economy with any number of goods and factors. It is shown that the change in the real exchange rate equals a simple weighted sum of the differences between the marginal propensities to consume and the marginal propensity to produce individual non-traded goods. Implications of the result are noted for a variety of applied questions, including the effects of foreign aid, the "Dutch Disease", and cross-country comparisons of purchasing power parity.