Non-linear multivariate adjustment of the UK real exchange rate

Abstract

Based on a multivariate non-linear model, this paper recognises an important role for the real exchange rate in affecting UK labour market conditions. The short-run real exchange rate adjusts quickly to disequilibrium deviations of the real exchange rate from its long-run level outside a rather wide interval band. When the real exchange rate is undervalued, short-run unemployment falls as firms respond to an improvement in domestic competitiveness by increasing their demand for labour. Further, there is a strong response of short-run unemployment to the disequilibrium error outside a narrow interval band. To the extent that the real exchange rate equation reflects monetary policy considerations, our results imply that unemployment can be targeted by economic policy. Furthermore, if economic authorities want to avoid large swings in unemployment then they should be prepared to intervene in exchange markets with the aim of keeping real exchange rate movements within a narrow interval band.Real exchange rate; Traded goods; Smooth Transition Vector Error Correction Model