The real exchange rate: an alternative approach to the PPP puzzle

We use a reduced form model to empirically examine the relative importance of nominal (relative money supply and current account) and real variables (terms of trade and industry productivity) in determining the bilateral real exchange rate between New Zealand and Australia. Our results show that real variables have a long-tenn impact on the real exchange rate, while shocks to monetary variables have only a short-term effect. Our results from time series support the Balassa-Samuelson effect. We also show that New Zealand and Australia bilateral real exchange rate with Japan as a base country shares a common stochastic trend, which can be interpreted in terms of optimum currency area. (C) 2002 Society for Policy Modeling. Published by Elsevier Science Inc. All rights reserved.