Real Exchange Rate Misalignments: Theoretical Modelling and Empirical Evidence

Abstract

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. Some countries, on the other hand, have pursued very active exchange rate policies in order to undervalue their currencies to foster growth through export promotion (e.g. China). Our goal is to assess whether these policies can sustain RER undervaluation. 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. With our novelty of modeling RER misalignments we estimate 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).