Assessing the Real Exchange Rate Misalignments: Is Real Undervaluation of the Currency Likely and Can It Be Sustained?

Abstract

There is a renewed debate on the role of exchange rate policies as industrial policy tools in both academic and policy circles. Policy practitioners usually examine real exchange rate (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. Anecdotal evidence shows that some countries have pursued very active exchange rate policies to promote the export sector and enhance growth (e.g. China) by undervaluing their currencies. The main goal of this paper is to provide a systematic characterization of real exchange rate undervaluations. We first calculate fundamental RER misalignments based on the long run RER equation derived from the theoretical model developed by Kubota (2009). Then, we construct a dataset of real undervaluation episodes. Second, we present some basic evidence on the co-movement of RER undervaluation and (real and nominal) macroeconomic aggregates. We specifically assess the behavior of macro aggregates during undervaluations using an “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.