Private Consumption, Nontraded Goods and Real Exchange Rate: A Cointegration_Euler Equation Approach

This paper presents an empirical study of real exchange rate movements from a consumer's perspective. Trade between two countries creates a link between real exchange rate and terms of trade. It is the private consumption of non-traded goods that induces an equilibrium relationship between real exchange rate and private consumption of traded and non-traded goods. We use Ogaki and Park's (1989) cointegration-Euler equation approach to explore long-run implications from the equilibrium relationship. Given the stationary preference shocks assumption, the testable restriction is that real exchange rate and private consumption of traded and non-traded goods in the home and foreign countries are cointegrated. The empirical evidence suggests that private consumption in the home and foreign countries accounts for a significant fraction of the long run movements of real exchange rate in South Korea and Taiwan. Accounting for real government consumption does not overturn the result.