Nominal shocks and real exchange rates: Evidence from two centuries

This paper employs structural vector autoregression methods to examine the contribution of real and nominal shocks to real exchange rate movements using two hundred and seventeen years of data from Britain and the United States. Shocks are identified with long-run restrictions. The long time series makes possible an investigation of how the role of nominal shocks has evolved over time due to changes in the shock processes or to structural changes in the economy which might alter how a shock is transmitted to the real exchange rate. The sample is split at 1913, which is the end of the classical gold standard period, the last of the monetary regimes of the 19th century. The earlier subsample (1795-1913) shows a much stronger role for nominal shocks in explaining real exchange rate movements than the later subsample (1914-2010). Counterfactual analysis shows that the difference between the two periods is mainly due to the size of the nominal shocks rather than structural changes in the economy. These findings are consistent with the view that the financial instability and frequent deflation of the 19th century had real economic effects.