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However, Edwards () has shown that these initial theoretical approaches were too simplistic.He has argued that a trade liberalization does not have an unambiguous effect, since there are two different effects at work, a substitution and an income effect, that operate in opposite directions.Given the existence of long-term deviations from PPP in some countries, scholars were interested in explaining these deviations; and those who believed that PPP theory does not hold attempted to identify the factors behind appreciations or depreciations of the real exchange rate.
This is the core of the PPP theory, which has been extensively tested empirically with different methodological approaches in order to demonstrate that exchange rate time series are stationary.
The evidence, however, is mixed (Froot and Rogoff ); and these inconclusive results have been explained as resulting from (1) the short time frame of the observation windows and (2) the particular exchange rate dynamics of the countries under analysis (e.g., in high-inflation economies, PPP theory appears to hold, while the evidence for normal economies tends to reject this thesis).
The study of the determinants of the real exchange rate is a topic that has received much attention in international economics.
The first theoretical approach to its conceptualization dates back to Cassel’s () thesis, which stated that there is an equilibrium exchange rate for money across different countries and that the exchange rate should converge to this value regardless of temporary fluctuations (i.e., appreciation or depreciation due to different inflation rates).
If this level is low, a decrease in tariffs will produce a real depreciation, as a substitution effect will dominate (i.e., the price of nontradables will diminish relative to that of exports).
But if the liberalization occurs with a large initial level of tariffs, there may be an increase in welfare (income effect), which may produce an excess demand for nontradables and their price will go upwards.
Thus, protectionism through tariff barriers, quotas or other forms restricts imports and consolidates a situation of REER appreciation.
Therefore, many authors have argued that trade liberalization leads to the opposite effect, a depreciation of the REER.
Early theoretical models support this hypothesis (Dornbusch ), the logic is straightforward: once a reduction in import tariffs is implemented, there is an imbalance in the current account as a results of the increasing demand for imports.
In turn, this induces the need to generate a depreciation in the real exchange rate.