An Alternative Theory of Long-run Exchange Rate Determination: an Empirical Application

Conventional exchange rate models are based on the fundamental hypothesis that, in the long run, real exchange rates adjust in such a way as to make countries equally competitive, eliminating trade surpluses and deficits. The contention of this book, based on the theoretical underpinnings of absolute competitive advantage, is that movements of long-run exchange rate are determined by real unit costs of tradable goods. According to this argument, the empirical finding of persistent trade imbalances is not the exception, but rather an anticipated outcome. When competitive absolute advantage replaces the, all too often embraced, principle of comparative advantage a framework emerges that stands in opposition to orthodox models. A theoretically grounded, empirically robust explanation of real exchange rate movements is constructed that can be of practical use to researchers, but also, and equally importantly, to policymakers.