A Real Di ff erential View of Equilibrium Real Exchange Rates ∗

This paper examines the interaction of G7 real exchange rates with real output and interest rate differentials. Using cointegration methods, we generally find a link between the real exchange rate and the real interest differential. This finding contrasts with the majority of the extant research on the real exchange rate real interest rate link. We then identify a new measure of the equilibrium exchange rate in terms of the permanent component of the real exchange rate that is consistent with the dynamic equilibrium given by the cointegrating relation. Furthermore, the presence of cointegration also allows us to identify real, nominal and transitory disturbances with only minimal identifying restrictions. Our findings suggest that misalignments are largely due to nominal shocks, but that their half-life is much lower than is suggested when purchasing power parity is used as the reference equilibrium. This has important implications for the persistence measures of real exchange rates that are reported elsewhere in the literature.