Dissecting Real Exchange Rate Fluctuations in China

ABSTRACT

This article uses a structural VAR model to investigate the sources of real exchange rate fluctuations in China over the period 1995Q1–2015Q4, taking into account five different types of macroeconomic shocks including technology, government spending, monetary policy, foreign demand, and risk premium shocks. These shocks are identified using sign restrictions derived from predictions of an open economy general equilibrium model calibrated to China’s economy. We find that foreign demand shocks are the most important driving force of China’s real exchange rate, which explains approximately 20% to 40% of the variance in 20 quarters. It is in line with the findings in the literature which show real demand shocks are the key contributor to fluctuations in the real exchange rate. Nominal shocks such as monetary policy shocks and risk premium shocks play relatively important roles at the short-term horizons, but their effects decay rapidly.

KEY WORDS:

• real exchange rate
• sign restriction
• VAR
• variance decomposition

Acknowledgments

We would like to thank the anonymous referees for very useful comments.

Notes

^1. Chang, Liu, and Spiegel (2015) use portfolio adjustment costs to capturing the UIP wedge caused by capital controls. Our settings generates a similar UIP wedge.

^2. Strictly speaking, we can not distinguish technology shocks from other types of supply shocks such as labor supply shocks using the sign restrictions in Table 2. Technology shocks in the article should be treated as supply shocks in broad terms.

^3. We first randomly draw a stochastic standard normal matrix X, and then impose QR decomposition on X, which gives an orthogonal matrix Q.

⁴ The raw data of M2 from the CEIC database has already been seasonally adjusted.

Additional information

Funding

This research is supported by National Natural Science Foundation of China (71403227).