While some attribute the rise in the volatility of real exchange rates since the collapse of the Bretton Woods system to the increased size and importance of real shocks, others maintain that increased monetary instability reflects central banks' greater discretion under floating. In Discussion Paper No. 951, Richard Clarida and Research Affiliate Jordi Galí estimate the relative contributions of real (supply and demand) shocks and nominal (monetary) shocks to real exchange rate fluctuations for Canada, Germany, Japan, and the UK vis-à-vis the US during 1973-92. They construct series of the four countries' real exchange rates against the dollar and their aggregate output relative to the US. In their model, monetary shocks can have no permanent effect on relative output or the real exchange rate and demand shocks are restricted to have no permanent effect on output, but supply shocks can have permanent effects on both output and the real exchange rate.

Their results indicate that monetary shocks account for more than one-third of the variability of the yen/dollar and Deutschmark/dollar real exchange rates, but their evidence is weaker concerning the influence of monetary shocks for Canada and the UK. Demand shocks are the most important source of real exchange rate volatility for all four currencies, while supply shocks appear to have played only a minor role. Finally, they compare the estimated impulse response functions to these three types of structural shock with those implied by a stochastic, dynamic version of the MundellFleming model. For all four countries, the short-run dynamic responses of output, real and nominal exchange rates and prices to monetary and demand shocks are consistent with the latter's predictions, and their estimates point to the presence of significant sluggishness in price adjustment and `overshooting'. Overall, these results imply that central banks have substantial powers to stabilize real exchange rates and that sluggish price adjustment must be incorporated into theoretical models seeking to explain their short-term fluctuations.

Sources of Real Exchange Rate Fluctuations: How Important are Nominal Shocks?
Richard Clarida and Jordi Galí

Discussion Paper No. 951, June 1994 (IM)