The real exchange rate (RER) misalignment is a key variable in academic and policy circles. Among policy circles, sustained RER overvaluations are observed by authorities for future exchange rate adjustments. In some cases with capital flows pouring into emerging markets, those countries have tried to remain competitive by pursuing very active exchange policies to undervalue their currencies and foster growth through export promotion (e.g. China). These\ud developments have led to a renewed debate on the role of exchange rate policies as industrial policy tools in both academic and policy circles. Policy practitioners usually examine RER misalignments to monitor the behavior of this key relative price and, if possible, exploit distortions in the traded and non-traded relative price to promote growth.\ud \ud The main goal of this paper is to provide a systematic characterization of real exchange rate undervaluations. What are the consequences of undervaluation? What are the main determinants of undervaluations? Could policymakers generate and sustain RER undervaluations? More pecifically, our goal is to assess whether policymakers can exploit (if any) the nexus between RER and policy to weaken the currency and promote growth through competitive valuations. In this context, this paper complements and improves upon the existing literature by formulating a theoretical based model to compute equilibrium real exchange rate and its misalignment and to estimate and calculate RER misalignments. One of the novelties is to derive and solve for what we call intertemporal BOP equilibrium and equilibrium in the tradable and non-tradable goods market based on the current account dynamics and Harrod-Balassa-Samuelson (HBS) productivities. After solving for the RER in the steady state, we estimate the fundamental RER equation using cointegration techniques for time series –i.e. Johansen's (1988,1991) multivariate analysis and the error correction model (ECM) by Bewley (1979) and Wickens and Breusch (1987)– and for heterogeneous panel data –i.e. the pooled mean group estimator (PMGE) by Pesaran, Shin and Smith (1999). An empirical novelty of this paper is to model\ud RER misalignments and estimating VAR models that link them with shocks to fundamentals and permits us to calculate the speed of reversion of RER misalignments. \ud \ud Once we estimate the equilibrium RER, we proceed to calculate the RER misalignment and, more specifically, we construct a dataset of real undervaluation episodes. Then, we present some basic evidence on the behavior of macroeconomic aggregates (output, demand, and inflation, among others) during undervaluation episodes using the “event analysis” methodology. Finally, we evaluate whether (and if so, to what extent) economic policies can be used to either cause or sustain real undervaluations. In this context we empirically model the likelihood and magnitude of sustaining RER undervaluations by examining their link to policy instruments (e.g. exchange rate regimes, capital controls, among other policies) using Probit and Tobit models, respectively
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