The response of exchange rates to permanent and transitory shocks under floating exchange rates

Using the joint behavior of inflation and real exchange rates, we develop an empirical model to uncover the sources of the fluctuations in the real dollar exchange rates of four major industrial countries under the current float. This model allows us to construct two time series for each country pair, one representing the permanent component of each real exchange rate, and the other the purely transitory component. Over the period as a whole, transitory shocks played a relatively small but statistically significant role. Real dollar exchange rates therefore did not simply evolve in response to permanent shocks. Instead, there are instances in which temporary shocks made a substantial contribution. We conclude that the random walk model, though an approximate statistical description of real-exchange-rate behavior, is a poor guide to model structure. (JEL F31).