In Search of Dominant Drivers of the Real Exchange Rate

We uncover the major drivers of macro aggregates and the real exchange rate at business cycle frequencies in Group of Seven countries. The estimated drivers of key macro variables resemble each other and account for a modest fraction of the real exchange rate variances. Dominant drivers of the real exchange rate are orthogonal to main drivers of business cycles, generate a significant deviation of the uncovered interest parity condition, and lead to small movements in net exports. We use these facts to evaluate international business cycle models accounting for the dynamics of both macro aggregates and the real exchange rate.