ACROSS TIME AND REGIMES: 212 YEARS OF THE US‐UK REAL EXCHANGE RATE

I. INTRODUCTION This paper examines the behavior of the real exchange rate under different nominal exchange rate regimes using monthly data on the US-UK exchange rate over the period 1794-2005. The 212-yr series encompasses five floating and four fixed exchange rate periods and includes a new monthly exchange rate series for the periods that precede the classical gold standard. Figures 1 and 2 show the behavior of the real and nominal exchange over the entire sample. Three key stylized facts emerge from the analysis: (a) real exchange rate volatility is higher when the nominal exchange rate is floating, (b) the contribution of price-level changes to real exchange rate movements has decreased over time, and (c) the persistence of real exchange rate has been considerably higher in the postwar period. The real exchange rate is the price of output in one country relative to another. That is, the real exchange rate is given by q = e[P.sup.*]/P, where P and [P.sup.*] are home and foreign price indexes and e is the nominal exchange rate, that is, the home price of foreign currency. A key question that can be examined with a series that includes multiple regimes is whether real exchange rate behavior is invariant to the nominal exchange rate regime, that is, whether the properties of q depend on whether e is fixed or floating. Mussa (1986) demonstrates that short-term volatility of the real exchange rate is lower when the nominal exchange rate is fixed. Mussa's study relies on postwar data from OECD countries, most of which had fixed exchange rates until Bretton Woods collapsed in the early 1970s and floated thereafter. As Grilli and Kaminsky (1991, hereafter GK) note, relying on such limited evidence is not sufficient to establish general validity of the proposition that real exchange rate volatility is higher under floating regimes. To remedy this, GK examined the US-UK real exchange rate using monthly data beginning in 1885. Their study encompassed three fixed rate periods: the classical gold standard, the interwar gold exchange standard, and Bretton Woods, and three floating periods: two interwar intervals and the post-Bretton Woods float. They conclude that "the nominal exchange rate regime is not as crucial to the behavior of the real exchange rate as previous analyses have suggested ... the behavior of the real exchange rate varies substantially across historical periods, but not nominal exchange rate arrangements (192)." In their analysis, the Bretton Woods period was characterized by a unique degree of stability. They argue that the commonly held belief that floating exchange rates lead to higher real exchange rate volatility is an artifact of the unusual stability of the 1950s and 1960s. [FIGURE 1 OMITTED] [FIGURE 2 OMITTED] The additional data used in this study encompass two additional floating rate periods and one additional fixed rate period. GK are surely correct that real exchange rate behavior varies across different time periods due to the evolution of institutions--for example, decreasing transaction costs, development of the financial system, and increasing nominal rigidity. Comparing historically adjacent fixed and floating regimes provides a rough way to "control" for long-run historical changes in order to see whether the nominal regime matters for the real exchange rate. Of all the periods examined, Bretton Woods clearly has the lowest real exchange rate volatility. However, Mussa's conclusion that real exchange rate volatility is higher in floating periods does not appear to be an artifact of this stability. Examining the entire 212-yr period, a consistent pattern emerges: every nominal regime switch from fixed to floating is associated with an increase in real exchange rate volatility, and every switch from floating to fixed is associated with a decrease. Although there is a consistent relationship between the real exchange rate volatility and the nominal exchange rate regime, the source and persistence of real exchange rate movements have evolved considerably over time. …