Equilibrium exchange rate of the Estonian kroon, its dynamics and impacts of deviations


The aim of the analysis presented here is to examine the behaviour of the real exchange rate of the Estonian kroon, to estimate its equilibrium value and investigate its impact on the competitiveness of Estonian economy. A brief account on possible measures of the real exchange rate (RER) is given, and then the real effective exchange rate (REER) weighted with domestic and foreign consumer price indices (CPI) is chosen for the estimation. A model for the equilibrium real exchange rate (ERER) determination suitable for a small open economy as Estonia is outlined and provides a theoretical basis for understanding what kind of fundamentals can affect real exchange rate behaviour. Given the short sample considered here, a single equation estimation method is used. The choice of fundamentals is determined both by particular features of the Estonian economy and data constraint. The fundamentals finally adopted are productivity differential between tradeables and nontradeables sectors, investment share, resource balance and nominal effective exchange rate. Having detected the existence of one cointegration vector between RER and fundamentals, it is possible to estimate the long-run relationship linking them and an error correction mechanism in order to have some information on short-run behaviour of the real exchange rate. Estimation results are then used to construct both ERER series and misalignment measures. To do this, some hypotheses on equilibrium/sustainable levels of fundamentals are set and discussed. Our simulation hence brings us to conclude that an appreciation of RER in the sample period occurred together with an appreciation of its equilibrium level. The latter appreciated slower, hence the initial undervaluation was corrected and the difference between RER and its equilibrium level shrank, leading to a slight overvaluation after the Russian crisis.

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Research Papers in Economics

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Last time updated on 7/6/2012

This paper was published in Research Papers in Economics.

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