This thesis documents the following facts in emerging markets: First, the real exchange rate (RER) puzzle exists. Volatility of RER in emerging markets is twice larger than volatility in developed economies on average. Second, RER is pro-cyclical and real interest rate is counter-cyclical. Third, significant comovement between real interest rates and RER is observed. Motivated by these facts, we explore whether shocks (permanent technology shock and interest rate shock) that emphasized in explaining business cycle can drive real exchange rate fluctuation in EMs. Specifically, we propose standard three sectors RBC-SOE model and apply Bayesian estimation to match Mexico data. RBC model with permanent technology shock can match both volatility and persistence of real exchange rate, while c...[ Read more ]

This thesis documents the following facts in emerging markets: First, the real exchange rate (RER) puzzle exists. Volatility of RER in emerging markets is twice larger than volatility in developed economies on average. Second, RER is pro-cyclical and real interest rate is counter-cyclical. Third, significant comovement between real interest rates and RER is observed. Motivated by these facts, we explore whether shocks (permanent technology shock and interest rate shock) that emphasized in explaining business cycle can drive real exchange rate fluctuation in EMs. Specifically, we propose standard three sectors RBC-SOE model and apply Bayesian estimation to match Mexico data. RBC model with permanent technology shock can match both volatility and persistence of real exchange rate, while consumption volatility is marginally larger than volatility of output. Variance decomposition suggests that permanent technology shock accounts for 17% of RER variance. Introducing financial friction improves model performance. Country premium shock explains 68% of RER variance and 55% of consumption growth variance.