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Real Exchange Rate and U.S. Manufacturing Profits: Theoretical Framework with Some Empirical Support

Clarida, Richard H.

This paper investigates the relationship between manufacturing profits and the real exchange rate. Using Marston's (1990) model of pricing-to-market, we identify two channels, a valuation channel and volume channel, through which changes in the real exchange rate can shift the profits of a price-setting exporter. Employing the econometric approach developed Johansen (1990; 1991), we estimate a dynamic vector error correction model on quarterly data for real US manufacturing profits and five variables that theory suggests should be useful in accounting for the behavior of real profits in an open economy: domestically sold outpput, the real exchange rate, real unit costs, the relative price of domestically sold output, and real foreign income. Finding evidence of cointegration, we estimate via maximum likelihood the single cointegrating relationship that is defined by the conditional probability distribution of real manufacturing profits implied by the VECM. We test, and confirm, that both real profits and the real exchange rate are elements of this cointegrating vector, and interpret this cointegrating relationship as a long-run open economy profits equation. Our estimates imply that, holding constant domestic sales, real unit costs, the relative price of domestic output, and real foreign income, the long-run elasticity of real profits with respect to the real exchange rate exceeds 0.80.

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Academic Units
Economics
Publisher
Department of Economics, Columbia University
Series
Department of Economics Discussion Papers, 613
Published Here
February 17, 2011

Notes

June 1992.

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