External Shocks - Purchasing Power Parity and the Equilibrium Real Exchange Rate - Working Paper 611

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Two approaches determine the equilibrium real exchange rate after external shocks: purchasing power parity (PPP) calculations and the Salter-Swan, tradables-nontradables model. Both methods face theoretical and empirical shortcomings and produce tensions. The paper resolves these issues by extending the Salter-Swan framework with imperfect substitutes for imports and exports. It yields a natural real exchange rate consistent with both PPP and an extended Salter-Swan model, captures terms-of-trade shocks and foreign capital inflows, and enables estimation with minimal additional information, aligning results with multisector CGE models.

LanguageEnglish

CategoryResearch & Report

FormatPDF

Pages35

Reading Time1 h 28 min

AccessFree to download

Introduction

A Single-Country, Two-Activity, Three-Commodity Model

The Analytics of the Equilibrium Real Exchange Rate

Alternative Approaches

Illustrative Empirical Examples

Cameroon

Indonesia

Conclusion

References

378.794G43455WP-611 wonzng PapersPURCHASING POWER PARITY,AND THEEQUILIBRIUM REAL EXCHANGE RATEby WORKING PAPER NO.611 EXTERNAL SHOCKS, Shantayanan DevarajanJohn F.Kennedy School of GovernmentHoend JInivsmitWAITE LIBRARY DEPT.OF AG &APPLIED ECONOMICS1994 BUFORD AVE.-232 COBUNIVERSITY OF MINNESOTAST.PAUL,MN 55108 U.S.A. | | DEPARTMENT OF AGRICULTURAL AND RESOURCE ECONOMICS
DIVISION OF AGRICULTURE AND NATURAL RESOURCES
UNIVERSITY OF CALIFORNIA AT BERKELEY | | --- | --- | | | WORKING PAPER NO.611
EXTERNAL SHOCKS.
PURCHASING POWER PARITY,AND THE
EQUILIBRIUM REAL EXCHANGE RATE
by
Shantayanan Devarajan
John F.Kennedy School of Government
Harvard University
Jeffrey D.Lewis
Harvard Institute for International Development
Harvard University
Sherman Robinson
Department of Agricultural and Resource Economics
University of California at Berkeley | | | California Agricultural Experiment Station
Giannini Foundation of Agricultural Economics
May,1991 | 378.794《3455-61 External Shocks, Purchasing Power Parity,and theEquilibrium Real Exchange Rate Shantayanan DevarajanJohn F.Kennedy School of GovernmentHarvard University Jeffrey D.Lewis Harvard Institute for International DevelopmentHarvard University Sherman Robinson Department of Agricultural and Resource EconomicsUniversity of California at Berkeley May 1991 WAITE MEMORIAL BOOK COLLECTIONDEPT.OF AG.AND APPLIED ECONOMICS1994 BUFORD AVE.-232 COBUNIVERSITY OF MINNESOTAST.PAUL,MN 55108 U.S.A. Table of Contents I INTRODUCTON…………………………………………………………………………1 II. A SINGLE-COUNTRY, TWO-ACTIVITY, THREE-COMMODITY MODEL ……………4 III. THE ANALYTICS OF THE EQUILIBRIUM REAL EXCHANGE RATE …………………7 IV. ALTERNATIVE APPROACHES……………………………………………………………………………………………14 V.ILLUSTRATIVE EMPIRICAL EXAMPLES …………………………………………………………………………18 Cameroon …………………………………………………………………………………………………………………………………………………………19 Indonesia …………………………………………………………………………………………………………………………………………………………22 VI. CONCLUSION ………………………………………………………………………………………………………………………………28 REFERENCES ………………………………………………………………………………………………………………………………30 # Abstract Two approaches are commonly used to determine the equilibrium real exchange rate in a country after external shocks: purchasing power parity(PPP)calculations and the Salter- Swan, tradables-nontradables model. There are theoretical and empirical problems with both approaches, and tensions between them. In this paper, we resolve these theoretical and empirical difficulties. We present a model which is a generalization of the Salter-Swan model that incorporates imperfect substitutes for both imports and exports. Within the framework of this model, there is a natural definition of the real exchange rate that is consistent both with the PPP approach and with the Salter-Swan model(suitably extended). Our model, however, is capable of capturing a richer set of phenomena, including terms-of-trade shocks and changes in foreign capital inflows,and also provides a practical way to estimate changes in the equilibrium real exchange rate,requiring little more information than that required to do PPP calculations. We also show that the results from our model are consistent with results from multisector computable general equilibrium(CGE)models,which generalize the trade specification of the small model. # I.INTRODUCTION· Faced with sharp increases in real interest rates,cutbacks in foreign lending,anddeteriorating terms of trade-all of which lower the sustainable level of a country's currentaccount balance—deveioping countries since the mid-1970s have been forced to reduce theirtrade deficits or,in some cases,to run surpluses.They have adopted“structural adjustment”programs,often with the assistance of the IMF or World Bank,aimed at facilitating thetransition to lower current account deficits.A common ingredient in all these programs isa real devaluation of

FAQs

Which two approaches are commonly used to determine the equilibrium real exchange rate after external shocks?

They are purchasing power parity (PPP) calculations and the Salter-Swan tradables-nontradables model.

What key theoretical extension does the paper introduce beyond the Salter-Swan model?

It generalizes the Salter-Swan model by incorporating imperfect substitutes for both imports and exports.

How does the proposed framework help estimate changes in the equilibrium real exchange rate?

It provides a practical way to estimate changes using little more information than required for PPP calculations, while remaining consistent with extended Salter-Swan results and multisector CGE models.

Sep 2, 2026

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