On the Real Exchange Rate as a Measure of Australia’s External Competitiveness

Abstract

The use of a country’s real effective exchange rate as a measure of external competitiveness implicitly assumes that, in the long run, purchasing power parity prevails between the country and its trading partners [Dornbusch (1985)]. A testable definition of long run equilibrium existing among non-stationary time series is provided in the recently developed theory of cointegration [Engle and Granger (1987)]. The paper extends earlier U.S. work in this area by Layton and Stark (1990) by investigating the existence of such a long run ‘statistical equilibrium’ between measures of the Australian inflation rate and an effective exchange rate adjusted inflation rate computed from Australia’s major trading partners.