HAIRCUTS OR HYSTERESIS - SOURCES OF MOVEMENTS IN REAL EXCHANGE-RATES

We empirically assess the importance of two sources of real exchange rate movements. In models where PPP holds only among traded goods, real exchange rate variation results from relative price movements within countries. An alternative explanation relies on hysteretic price-setting and nominal exchange rate changes. Using disaggregated price data from 11 OECD nations, we find some support for the non-traded goods models. For examples, prices of haircuts in Canada and the United States are unrelated in the long run. We find stronger evidence to support models that emphasize sticky prices, transportation costs, or other impediments to frictionless trade.