An alternative theory of real exchange rate determination: theory and empirical evidence for the Mexican economy, 1970-2004

It is well known that mainstream approaches to real exchange rate determination (e.g those based on purchasing power parity) can fail because price adjustments between trading partners do not occur simultaneously. This paper puts forth an alternative theory with regard to the Mexico-United States (us) real exchange rate. Our approach takes a long term perspective and employs a classical political economy framework developed by Shaikh (1980, 1991, 1998, 1999b), with foundations in the works of David Ricardo and Karl Marx Unlike mainstream theories which focus on relative consumer or producer prices, we argue that relative real unit labor costs of the Mexican and us manufacturing sectors is a good indicator of the effective real exchange rate between the two countries. The empirical methods used in this paper include unit root tests and a co-integrated vector autoregression model (VAR). This paper seeks to provide some critical insights with regard to relative prices and relative and absolute competitiveness between Mexico and the United States.