Effects of the real exchange rate on the output gap: evidence from

Switzerland
Alessandra Stampi-Bombelli, Ivan Hajdukovic, Erwin Lefoll
HEC - University of Lausanne

May 29, 2016

Abstract
This project assesses the effects of the real exchange rate on the real output gap of Switzerland by
considering quarterly data from 2000:I to 2015:IV. By using a VAR analysis with two distinct models
we find that a real appreciation decreases the output gap in the short run. We then construct a
counterfactual output gap in the absence of structural shocks due to the real exchange rate. Results
suggest that the positive output gap would have been wider in the absence of the Swiss National
Banks decision to abandon the peg with the euro in early 2015.
Keywords: Output gap, Real exchange rate, VAR, Switzerland
1. Introduction
On January 15, 2015, the Swiss National Bank (SNB) decided to abolish the minimum exchange
rate of 1.20 with the euro which was introduced in 2011. This exceptional measure was a surprise
for the markets and many agents expected that this would have an negative impact on the real
GDP growth of Switzerland. Since we consider a small open country, we expect that a change
in the real exchange rate (RER) will affect the balance of trade and the economic performance of
Switzerland. This is mainly due to the fact that trade is an important share of Swiss income. In
fact, the exports to the Eurozone accounted for some 44% of total exports in 2015 (BNS 2016).
According to macroeconomic theory, we know that if the Marshall-Lerner condition is satisfied, an
appreciation of the franc will make the domestic products of Switzerland become more expensive
for the Eurozone and this will cause a reduction of the Swiss value of exports. This condition states
that a currency appreciation will only lead to a deterioration of the balance of trade if the sum
of the long-term export and import demands elasticities is greater than one. On the other hand,
foreign products become less costly and this will cause an increase in imports. Hence, we expect
to have a negative effect of the francs appreciation on the output gap via the deterioration of the
balance of trade.
In this paper, we are going to study the relationship between two variables: the output gap
and the real exchange rate (RER) of the Swiss franc to the euro. We would like to observe how
the real GDP and the RER mutually affect each other and, in particular, to measure the effect
of a RER shock on the output gap. To do so, we estimate two distinct models by using a vector
auto-regressive model (VAR). The first model includes the RER and the output gap as endogenous
variables whereas the second model adds inflation as a third endogenous variable.
Graph 1 shows the evolution of the output gap and real exchange rate EUR/CHF between
2000 and 2015. Although the relationship throughout the fifteen years is not obvious, we would
rather expect a real depreciation to cause an increase in the output gap, and vice versa. In fact, we
observe a clear decrease in the output gap around the same time of the francs appreciation in the
first quarter of 2015.

Section 2 discusses the theoretical links between

the RER and output. We will also give some real
evidences concerning the exchange rate policy in
Switzerland from 2011. Section 3 examines the data
and the methods that we used in order to build the
VAR model. Section 4 contains the VAR analysis
for both specifications, their impulse response functions, and forecast error variance decompositions.
Section 5 contains the counterfactual output gap in
the absence of structural shocks attributable to the
RER (an analysis inspired by Blanchard and Quah
(1988)). The final section summarizes the findings.
2. SNB Monetary Policy and Potential Links
between Output and the Real Exchange Rate

Graph 1

Switzerland has the particularity of having an exchange rate policy between floating and fixed.
The main reason why the SNB set the minimum exchange rate of 1.20 in 2011 is that it reduced the
uncertainty of the exchange market in a period of financial crisis and it prevented the country from
experiencing a recession period by fixing a limit to the appreciation of the franc. Fixed exchange
rates have the disadvantage of not allowing countries to conduct independent monetary policy since
Central Banks have to purchase and sell foreign currency in order to maintain the peg (this is
referred to, in literature, as the Impossible Trinity). Monetary policy cannot, therefore, focus
on price stability in the country. This can partially explain why this policy is used temporarily
and why the SNB decided to abolish the minimum exchange rate of 1.20 in January 2015. Its
important to precise that the context today is different compared to the 2007-2011 crisis period and
that maintaining a peg would be less appropriate in this moment.
To better understand the links between output and the real exchange rate, recall that the latter
can be seen as the nominal exchange rate (NER) adjusted for prices level in two economies:
q=s

p
p

where q is the RER, s is the nominal exchange rate CHF/EUR, p is the consumer price index
(CPI) for the Eurozone, and p is the CPI for Switzerland. It represents the relative price between
foreign goods (tradable) and domestic goods (non-tradable). An increase in s, holding the relative
price level fixed, would lead to a real depreciation, causing the economy to become relatively more
competitive. This could lead to an increase in the output gap if the Marshall-Lerner condition is

satisfied via the trade balance. Similarly, if pp increases, domestic goods become relatively less
expensive and the trade effect could temporarily increase output.
3. Data and Methodology
To analyse the relationship between output gap, RER, and inflation for Switzerland, we considered the period from 2000 to 2015, by using quarterly data on all three variables with a total of 64
observations. In absence of data on the RER, we computed it by taking the NER and by correcting
for the relative CPI of both economies. Output gap refers to the HP filtered real GDP from its long
run trend, therefore the business cycles. Inflation refers to the growth rate of the Consumer Price
Index. The Data Appendix (Table A.1) contains a full description of the series (frequency, unit,
2

data source, and transformation).

Firstly, we performed a Augmented Dickey-Fuller test (Table A.2) to test for non-stationarity.
The test suggests that the RER process is not stationary since we cannot reject the presence of
a unit root. We transformed the data by computing the first difference of the real exchange rate
to remove stochastic trends. Real GDP has a clear positive trend, therefore we took the output
gap as often used in literature. As we expect that a RER shock will create a business cycle, we
found legitimate to choose this variable. Finally, concerning inflation, we used CPI year on year log
difference: that is to say the growth rate of the CPI in one quarter with respect to the same quarter
the year before. As we noticed a negative trend in inflation, we detrended the data by taking the
residuals from the regression of inflation on time. This process was seen to be stationary.
To select the appropriate number of lags for our VAR models, we considered four different criteria. Table A.3 shows the optimal lag selection for the first model (RER, GDP): every criterion
suggests to choose two lags respectively for each endogenous variable. Table A.4 shows the lag selection for the second model (RER, INF, GDP). We follow the AIC criteria which indicates, again,
two lags for each endogenous variable.
Finally, all the eigenvalues lie inside the unit circle for both models, which indicates that the
VARs satisfy the stability condition.
4. VAR Analysis
This section presents the empirical results of the two main VAR models that we estimated. We
specified the first model with two endogenous variables with the particular order of: first difference
RER and output gap. We then specified the second model with three endogenous variables with
the particular order of: first difference RER, inflation, and output gap. This ordering is in line with
the literature (Berument and Pasaogullari 2003, Kamin and Rogers 2000).

4.1. Model 1: RER, output gap


  
dRERt
c
= 1 +
cGDPt
c2

(11)

(12)

1
1
(21)
(22)
1
1

!

dRERt1
cGDPt1

(11)


+

(12)

2
2
(21)
(22)
2
2

!
  dRER 
dRERt2
t
+ cGDP
cGDPt2
t

We imposed short-run restrictions which prevent a structural shock from affecting an endogenous
variable contemporaneously. The goal is to give impulse response functions a more causal meaning.
In order to estimate the contemporaneous effect of a given shock on the endogenous variables, we
used the Cholesky decomposition. We imposed one fundamental restriction which is that a shock
of the GDP does not impact the RER contemporaneously. To do so, we set entry B12 of the B
matrix equal to zero (refer to Model A.1 in the Appendix). We think that the output shock, which
could be, for instance, a supply shock, increases the output gap contemporaneously, but we expect
it to have an effect on the RER only after one quarter.
Computing the B matrix, we find that a positive shock of the RER growth (1% standard
deviation increase) will contribute to increase the output gap by 0.084% contemporaneously.
Figure A.1 displays the impulse response functions for the first model. We can see that a 1%
standard deviation increase of the RER will contribute to an initial increase in the output gap of
over 0.2% in the first quarter. This positive effect then decreases and dies out after approximately
eight quarters. This means that a depreciation (i.e. increase in the RER) of the Swiss franc will
increase the output gap for about two years with a peak occurring right after the first quarter. This
result is only significant at the 95% level for the first quarter. Concerning the effect of the supply
3

shock on the RER, we can see that a positive shock (1% standard deviation increase) will cause
an appreciation of the currency in the first quarter. This effect then decreases and dies out after
approximately seven quarters. This result, however, is not statistically different from zero.
In Table A.5, we present the forecast error decomposition of the variables used in the first
model. It shows how much of the forecast error variance can be attributed to innovations in the
other variables or to own innovations. The variables in the rows are the ones whose forecast error
variance decomposition are in question, and the variables in columns are those whose innovations
constitute the fraction of the variables in the column. We have reported the FEVD at the 1, 2,
6, 12, and 20 horizon. Initially, innovation in the RER accounts for only 4% of the variation in
output gap. However, starting from the second horizon, it accounts for approximately 10% of the
variation. Another important result is that innovations in output will account for 2.4-3.9% of the
forecast error of the RER, the rest being explained by its own innovations. These findings suggest
that variations in output are mostly attributable to own innovations, however a non-negligible share
is given by the movements of the RER.
To check the robustness of these results, we estimated an alternative model with a different
ordering of the endogenous variables namely: output gap and first difference RER. This means
that we imposed, this time, the restriction that a RER shock does not impact the output gap
contemporaneously. The results also suggest that a positive RER shock contributes to a temporary
increase in the output gap. This led us to conclude that our results are robust to the choice of the
short-run restrictions.
However, one shortcoming of this model is that it does not include monetary policy. Since we
focus more on the short-run effects, we make the assumption that prices are sticky for a certain
period of time. This implies that the monetary policy could have some real effects on the RER and
on the output gap. In section 4.2 we present a second alternative model with inflation as a third
endogenous variable.

4.2. Model 2: RER, inflation, output gap

(11)
(11)
dRER
(12)
(13)
(12)
(13)
1
1
1
2
2
2
dRERt
c1
dRERt1
dRERt2
t
(21)
(21)
(22)
(23)
(22)
(23)
F
IN Ft = c2 +

IN
F
IN
F
IN
+
+
1

1
1
2
2
2
t1
t2
t
(31)
(32)
(33)
(31)
(32)
(33)
cGDPt
c3
cGDPt1
cGDPt2
cGDP
t
1
1
1
2
2
2
Adding inflation allows us to better distinguish the different shocks: we can now differentiate
between the productivity shock, the nominal shock (which includes decisions of the SNB regarding
foreign exchange policy), and the monetary policy shock (in the choice of the interest rate). The
Cholesky decomposition is again used to identify the structural shocks. As restrictions, we assumed
firstly that monetary policy and productivity shocks will not contemporaneously affect the RER. We
assume secondly that the productivity shock will not affect inflation contemporaneously. Theory
and literature suggest that all three shocks will affect the GDP contemporaneously by creating
business cycles. To do so, we set entries B12 , B13 and B23 of the B matrix equal to zero (refer to
Model A.2 in the Appendix).
Figure A.2 displays the impulse response functions for the three endogenous variables. These
results indicate the same direction and magnitude of the effect of the RER (nominal) shock on the
output gap: a positive shock (1% standard deviation increase) will contribute to increase the output
gap by 0.084% contemporaneously. This positive effect then decreases and dies out after a slightly
more rapidly than in the first model (after approximately seven quarters). This again means that
a depreciation (i.e. increase in the RER) of the Swiss franc will create a positive output gap for
4

about two years with a peak occurring right after the first quarter. Concerning the others results,
the main points to note are that the productivity shock (output shock) still induces the RER to
appreciate. In the short run the nominal and, due to sticky prices, real exchange rate appreciate
and the output gap increases. Eventually, prices increase and the output gap and RER return to
their previous values.
In Table A.6, we present the forecast error decomposition of the variables used in the second
model. One critical result is that innovations in RER (nominal shock) account for less (6.8%) than
the variation in output found in the first model. This is due to the inclusion of inflation (monetary
policy shock) in the second model which explains approximately 5% of the forecast error variance.
As in the first model, RER is mainly explained by own innovations. Regarding inflation, the effect
of innovations in output (productivity shock) have a relatively large effect from the sixth horizon
onwards (18%).
5. Counterfactual Economy
In this section, we want to see the time series of the output gap that would have been observed
in the absence of innovations in RER. The methodology we used was inspired by Blanchard and
Quah (1989). To do so, we set the structural shock due to the RER equal to zero udRER
= 0 in
t
the first model. In the second model, we set the structural RER (nominal) shock equal to zero
om = 0. In the absence of the RER shock in January 2015 and in accordance with the MarshalluN
t
Lerner condition, we expect the output gap to be above its actual level in the following quarters.
This is, in effect, what we find, as can be seen in Figures A.3 and A.4. In other words, had the
SNB not abandoned the peg with the euro, the output gap would have been 0.5-1% higher than
it actually was during the year that followed (see graph on the right of figure A.3). Recall that
the forecast error variance of the RER shock accounts for approximately 10% of the variation of
the output gap in the first model. Adding inflation in the second model reduces the forecast error
variance of the RER shock (nominal) to approximately 6.8% of the variation in the output gap. We
therefore notice, in Figure A.4 that the output gap computed in the absence of innovations in the
first model deviates more from its actual value than the one computed in the second model.
Its also important to notice that, in both models, in the period preceding the establishment
of the peg (September 2011), the counterfactual economy would have been stronger than if there
hadnt been shocks in RER. In fact, the peg was established precisely because the franc had been
greatly overvalued in the preceding years. Therefore, by cancelling out the structural shock of the
RER, we see that the increased trade balance would have induced a higher GDP due to a more
correct valuation of the currency (i.e. the franc would have been weaker).
6. Conclusion
In this study, even though our results are not highly significant, we find that the RER movements
are important in explaining the variability of output. In particular, we find that a positive RER
shock increases the output gap in the short term.
The SNB abolished the peg with the aim of helping the Swiss economy. On one hand, however,
according to our results, the output gap was hurt in the short run. On the other hand, since the
long run impact is still unknown, we cannot conclude that this policy was ineffective. It would
be interesting to perform this same study in a few years to see if maintaining the peg would have
effectively hurt the economy in the long run.

Appendix A.
Variable

Description

Frequency

Unit

GDP Cycle

Percentage deviation from the

long run trend (potential GDP)

Quarterly,
end of period

Percentage
deviation from the
long run trend

Real Exchange Rate

First difference of
nominal exchange rate CHF/EUR,
adjusted by the relative price level

Quarterly,
end of period

Growth with respect

to last quarter

Quarterly,
end of period

Percentage
change from the
same quarter, precedent year

Inflation

Detrended, year on year, growth rate

of CPI (same year, subsequent years)

Source
SECO (State
Secretariat
for Economic
Affairs)
Federal
Statistical
Office

Original Variable
Real GDP,
seasonally adjusted,
in millions of
2010 CHF
-Nominal Exchange Rate
-CPI Switzerland
-CPI Euro Zone

Federal Statistical
Office

Consumer Price Index

(december 2015=100)

Transformation
HP filter with
=1600
CP I EU

RERt = N ERt CP I tCH , dRERt = RERt

t

Taking the residuals of

CP It
ln CP
It4 = + t +

Table A.1: Data Appendix

Unit Root Test

RER

GDP

CPI

Level

First Difference

Year on Year
Difference

-0.516

-3.955***

-1.888

Log Level

Log First
Difference

HP Filtered

-0.410

-3.869***

-3.284**

Level

Log First
Difference

Year on Year Log

Difference (Detrended)

-1.933

-5.733***

-4.313***

Table A.2: Augmented Dickey-Fuller test (2 lagged differences).

*** Significant at the 1 percent level. ** Significant at the 5 percent level.
* Significant at the 10 percent level.

Number of lags
FPE
AIC
HQIC
SBIC

1
4.8e-08
-11.1828
-11.096
-10.9556

2
3.9e-08*
-11.3937*
-11.2489*
-11.0149*

3
4.2e-08
-11.3227
-11.1201
-10.7924

4
4.7e-08
-11.2040
-10.9434
-10.5222

5
5.1e-08
-11.1272
-10.8087
-10.2938

6
5.4e-08
-11.0852
-10.7088
-10.1003

7
5.0e-08
-11.1723
-10.7381
-10.0360

Table A.3: Lag Selection for Model 1 (RER, GDP)

* indicates the optimal number of lag

8
5.6e-08
-11.0702
-10.5781
-9.78232

9
6.2e-08
-10.9984
-10.4484
-9.55903

10
7.3e-08
-10.864
-10.256
-9.27307

Number of lags
FPE
AIC
HQIC
SBIC

1
1.4e-12
-18.7645
-18.5897*
-18.3056*

2
1.3e-12*
-18.8553*
-18.5495
-18.0523

3
1.6e-12
-18.6447
-18.2079
-17.4975

4
2.1e-12
-18.3977
-17.8298
-16.9063

5
2.4e-12
-18.2973
-17.5983
-16.4617

6
2.9e-12
-18.1897
-17.3596
-16.0100

7
2.7e-12
-18.3186
-17.3575
-15.7947

8
3.3e-12
-18.2155
-17.1233
-15.3474

9
3.4e-12
-18.3405
-17.1173
-15.1283

10
4.1e-12
-18.3283
-16.974
-14.7719

Table A.4: Lag Selection for Model 2 (RER, INF, GDP)

* indicates the optimal number of lag

Model A.1: Cholesky Decomposition Model 1

 dRER  
  dRER 
B11
0
t
ut
=
B12 B22
cGDP
ucGDP
t
t

0.03520
B=
0.00084

0
0.00411

The B matrix shows the Cholesky decomposition. We imposed one restriction which is that a shock of
the GDP does not impact the RER contemporaneously. dRER represents the first difference of the RER
and cGDP represents the GDP cycle.

Figure A.1: Impulse Response Functions

Model 1 (RER, GDP)

Real Exchange Rate

Output Gap

Real Exchange Rate

2
6
12
0.976
0.962
0.961
(0.031) (0.042) (0.042)
0.102
0.096
0.095
(0.081) (0.107) (0.108)

1
1
(0)
0.040
(0.049)

20
0.961
(0.042)
0.095
(0.108)

1
0
(0)
0.959
(0.049)

Output Gap
2
6
12
0.024
0.038
0.039
(0.031) (0.042) (0.042)
0.898
0.904
0.905
(0.081) (0.107) (0.108)

20
0.039
(0.042)
0.905
(0.108)

Table A.5: Forecast Error Variance Decomposition

Model 1 (RER, GDP)
Model A.2: Cholesky Decomposition Model 2
dRER
N om
ut
B11
0
0
t
M onpol
F
IN

B
B
0
=
u
21
22
t
t
cGDP
rod
B31 B32 B33
t
uP
t

0.03513
0
B = 0.00079 0.00532
0.00084 0.00099

0
0
0.00400

The B matrix shows the Cholesky decomposition. We imposed two restriction namely that the monetary
policy and productivity shocks will not affect contemporaneously the RER and that the productivity shock
onpol
om
is the monetary
will not affect inflation contemporaneously. Note that uN
is the nominal shock, uM
t
t
P rod
policy shock, and ut
is the productivity shock.

Figure A.2: Impulse Response Functions

Model 2 (RER, Inflation, GDP)

Real Exchange Rate

Output Gap
Inflation

1
1
(0)
0.040
(0.050)
0.022
(0.038)

Real
2
0.949
(0.048)
0.092
(0.080)
0.022
(0.042)

Exchange
6
0.919
(0.063)
0.070
(0.091)
0.021
(0.045)

Rate
12
0.917
(0.064)
0.068
(0.090)
0.022
(0.045)

20
0.917
(0.064)
0.068
(0.090)
0.022
(0.045)

1
0
(0)
0.904
(0.073)
0
(0)

Output Gap
2
6
12
0.012
0.029
0.030
(0.024) (0.037) (0.037)
0.845
0.890
0.878
(0.098) (0.098) (0.102)
0.056
0.180
0.185
(0.043) (0.086) (0.129)

20
0.030
(0.037)
0.878
(0.102)
0.185
(0.129)

Table A.6: Forecast Error Variance Decomposition

Model 2 (RER, Inflation, GDP)

1
0
(0)
0.056
(0.057)
0.978
(0.038)

2
0.039
(0.048)
0.063
(0.066)
0.922
(0.060)

Inflation
6
12
0.052
0.053
(0.051) (0.051)
0.040
0.054
(0.039) (0.055)
0.799
0.794
(0.132) (0.132)

20
0.053
(0.051)
0.054
(0.055)
0.794
(0.132)

Figure A.3: Graph on the left: period 2000-2015. Graph on the right: period 2010-2015

Figure A.4

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