DP209 | Determinants of the Equilibrium Real Exchange Rate

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01/12/1987

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Abstract

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.