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Through the Looking Glass: A WARPed View of Real Exchange Rate History

Douglas Campbell () and Ju Hyun Pyun

MPRA Paper from University Library of Munich, Germany

Abstract: Commonly used trade-weighted real exchange rate indices are computed as indices-of-indices, and thus do not adequately account for growth in trade with developing countries. Weighted Average Relative Price (WARP) indices solve this problem but do not control for productivity differences, as developing countries are observed to have lower price levels via the Balassa-Samuelson effect. In this paper, we remedy these problems in two ways. First we propose a Balassa-Samuelson productivity adjustment to Weighted Average Relative Price indices (BS-WARP). Secondly, we introduce a Weighted Average Relative Unit Labor Cost index (WARULC) for manufacturing and show that this measure does a much better job predicting trade imbalances and declines in manufacturing employment than the IMF's Relative ULC measure created as an index-of-indices. Our series reveal that for many countries currently mired in liquidity traps, relative prices reached historic highs heading into the financial crisis of 2008. We document that in 2002 -- during the surprisingly sudden collapse in US manufacturing -- US relative prices had not been that high relative to trading partners since the worst year of the Great Depression.

Keywords: Real Exchange Rate Indices; Relative Unit Labor Cost Indices; Balassa-Samuelson; Trading Partner Substitution Bias (search for similar items in EconPapers)
JEL-codes: C43 F31 F32 N7 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-opm
Date: 2014-05-10
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