Real exchange rates, trade balances and nominal shocks: Evidence for the G-7

To identify nominal shocks in structural VAR models of open economies, it is common practice to use purchasing power parity as a long-run identifying restriction so that there are no long-run effects of nominal shocks on real exchange rates. However, in some recent open economy intertemporal models with sticky prices, nominal shocks can have long-run effects on both real exchange rates and trade balances. In this paper, structural VAR models for the G-7 are identified in such a way that nominal shocks, at least potentially, can have long-run effects on a country's real exchange rate. For the G-7, nominal shocks are found to have a significant long-run effect on each country's trade balance over the post-Bretton Woods period. We do not have to appeal to hysteresis effects to explain this finding for trade balances, since nominal shocks are found to have a significant long-run effect on each country's real exchange rate.