Understanding Korea's long-run real exchange rate behavior

Douglas Irwin and Maurice Obstfeld

No WP24-17, Working Paper Series from Peterson Institute for International Economics

Abstract: Korea's real exchange rate has displayed a mild downward trend since the 1980s, with fluctuations of ±20 percent around that trend. This pattern is surprising because the classic Harrod-Balassa-Samuelson framework suggests that countries experiencing rapid growth in the productivity of their tradable industries should experience real currency appreciation over time. The paper decomposes the sources of change behind the Korean won's real exchange rate into internal price drivers (the relative price of nontradable goods) and external price drivers (the international relative price of tradable consumption goods, which is heavily dependent on the nominal exchange rate). The paper finds that, on average, the variability in Korea's real exchange rate, even over long periods, is overwhelmingly due to external price factors. Given the persistent medium-term effects of nominal exchange rate changes on the real exchange rate, the Korean policy of intervening in foreign exchange markets to smooth exchange rate fluctuations appears prudent. However, the paper also find that over the entire period 1985-2023, internal price factors are the main explanator of the won's real depreciation. This finding poses a puzzle for standard accounts of the linkage between productivity growth and real exchange rates.

Keywords: Korean won; real exchange rate; Harrod-Balassa-Samuelson model; Baumol-Bowen effect; terms of trade (search for similar items in EconPapers)
JEL-codes: F31 F41 F63 N15 (search for similar items in EconPapers)
Date: 2024-07
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Working Paper: Understanding Korea’s Long-Run Real Exchange Rate Behavior (2024)
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