NATREX AND DETERMINATION OF REAL EXCHANGE RATE OF RMB

In this paper, we analyze the movements of the real exchange rate in China. Our empirical evidence shows that the purchasing power parity does not hold in the long run, and the real exchange rate is non-stationary. The decomposition of the movements of the real exchange rate also indicates that real shocks result in permanent changes in the real exchange rate whereas nominal shocks just result in temporary changes. Based on these facts, we apply NATREX approach to analyze the determination of real exchange rate in China. The NATREX model successfully explains the evolution of the real exchange rate in China: The real exchange rate in the long run is determined by the real fundamentals including the productivity at home and abroad, and the domestic time preference. In the long run, a rise of the domestic productivity significantly appreciates the real exchange rate whereas a rise of the foreign productivity or a rise of the domestic time preference significantly depreciates the real exchange rate. We also find that the estimated NATR.EX rate converges to the steady-state exchange rate in the long run. Although there are short-run fluctuations around the NATREX rate, the real exchange rate will converge to the NATREX rate over time.