This paper contrasts real exchange rate (RER) measures based on different deflators (CPI, GDP
deflator, and ULC) and discusses potential implications for the link—or lack thereof—between
RER and external balance. We begin by documenting patterns in the evolution of different
measures of RERs, and confirm that the choice of deflator plays a significant role in RER
movements. A subsequent empirical investigation based on 35 developed and emerging market
economies over 1995 to 2014 yields comprehensive and robust evidence that only the RER
deflated by ULC exhibits contemporaneous patterns consistent with the expenditure-switching
mechanism. We rationalize the empirical findings by introducing a simple model featuring
nominal rigidity and trade in intermediate goods as the one in Obstfeld (2001) and Devereux
and Engel (2007), which is shown to generate qualitatively identical patterns to empirical
findings.
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