data for 17 industrialised countries to implement a panel version of the test developed by Mark (1995), found that monetary fundamentals outperform a random walk (as well as PPP fundamentals) at short and long horizons. Rapach and Wohar (2002), using long historical series for 14 advanced economies, documented some support for a simple form of the longrun monetary model. Cerra and Saxena (2010) also provided evidence supporting the monetary approach.<sup>42</sup> Some studies confirm the Balassa-Samuelson hypothesis of a link between productivity and exchange rates, especially over the long run (Balassa (1964) and Samuelson (1964)). However, the channels that generate this effect appear to be more complex than the traditional view suggests (Chong et al (2012) and Bordo et al (2017)). In particular, while higher labour productivity tends to lead to real exchange rate appreciation, which is consistent with the traditional view that richer countries have stronger exchange rates, the productivity effect is transmitted through relative prices between tradable goods rather than through the relative prices of tradable and non-tradable goods (Lee and Tang (2007) and Ricci et al (2013)). Other evidence regarding the effect of productivity on the real exchange rate is more ambiguous. Chinn and Johnston (1999) and Fitzgerald (2003), for example, find little evidence of a long-term relationship between real exchange rates and productivity differentials (see further Froot and Rogoff (1995), Tica and Druzic (2006) and Bordo et al (2017)).

The literature also considers the roles played by many other “fundamentals” in explaining the (real) exchange rate. For example, several papers have studied the effects of fiscal spending and deficits on the real exchange rate (Bouakez and Eyquem (2015) and Alves da Silva et al (2015)). Following work by Monacelli and Perotti (2011), Ravn et al (2012) find that increases in government spending can lead to a depreciation of the real exchange rate in some advanced economies. However, this finding contradicts the predictions of many traditional models (see Kim and Roubini (2008) for a review and estimates for the United States).

# Exchange rates, prices and activity

There is a vast empirical literature on the linkages between exchange rates, prices and macroeconomic outcomes (including the current account and external adjustment), with the major caveat that many of these relationships are endogenous and simultaneous. Moreover, a number of empirical puzzles involving those linkages remain, as discussed further in the next sub-section.

Exchange rates and prices. Empirical evidence supports some of the basic channels through which exchange rates affect export and import prices (Burstein and Gopinath (2014)). Understanding the quantitative importance of linkages between exchange rates and prices is an important step since these linkages are influential in shaping how fluctuations in exchange rates may subsequently affect macroeconomic aggregates. While deviations from the law of one price remain one of the most fundamental puzzles, exchange rates have been found to have a quantitatively significant impact on both import and export prices, especially in the long run. For example, in advanced countries about 64% of the change in exchange rates is estimated to be transmitted to import prices after one year (IMF (2007) and Choudhri and Hakura (2015)).

> 42 The hump-shaped behaviour documented by Eichenbaum and Evans (1995) has been shown by Steinsson (2008) to be consistent in the context of a two-country sticky-price business cycle model. See Engel et al (2008) for a view suggesting that exchange rate models do not perform as poorly as commonly thought.

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