Abstract
This study examines episodes of sharp depreciation of the real exchange rate that occurred in 1980–2009, with an emphasis on prolonged depreciations that did not soon wind down. Previous research focused on sharp nominal depreciations (such as Kaminsky et al. (1988), Frankel and Rose (1996), Eichengreen et al. (2002) and Bussiere (2013)), and found a large number of variables that could signal such an occurrence. A sharp and prolonged real depreciation is a rarer occurrence, reflecting a sharp and prolonged decline in the relative price of domestically produced goods relative to goods produced abroad, and the factors behind it have barely been studied in the empirical literature. An empirical examination of the real exchange rate (REER, which is calculated by the IMF) indicates that the most notable features that preceded a sharp and prolonged real depreciation are a large and prolonged Current Account deficit and a fixed exchange rate regime. Most of the sharp depreciations did not derive from overly optimistic expectations prior to the depreciation—the growth rate two years before the sharp depreciation was low relative to the long term average (excluding the sharp depreciations that occurred in East Asia in the second half of the 1990s). High inflation and low foreign currency reserves increase the chance of a sharp and transitory nominal depreciation, but were not found to have an effect on the probability of a sharp and prolonged real depreciation. The phenomenon of sharp depreciations is related to the low elasticity of exports and imports (the Current Account) with regard to the real exchange rate: a reduction in the Current Account deficit requires a large and prolonged real depreciation and sometimes even such a depreciation does not suffice because the Marshall Lerner conditions are not satisfied.