Re-examining the Sources of Real Exchange Rate Fluctuations: A Rational Expectations Structural VAR Approach

To explicitly take into account market expectations for real exchange rate fluctuations, this paper proposes a rational expectations structural VAR (RE-SVAR) method to decompose structural shocks. An exogenous shock not only has effects on real exchange rates directly, but also has indirect effects through the change in predictions for other fundamental variables. The RE-SVAR method imposes all these direct and indirect channels to decompose the sources of real exchange rate fluctuations. We find that the over-identifying restrictions implied by our model cannot be rejected for Canada, France, Italy, and Japan. Our results also indicate that private expenditure shocks are the most important source of real exchange rate variations for France and Italy, monetary shocks are most important for Canada, and foreign price shocks are most important in the long run for Japan. Moreover, supply shocks have a small but significant explanatory power fot real exchange rate variations only in France.