Taylor and Sarno (2001) estimate the equilibrium real exchange rate for different sets of
transition economies. They find varying degrees of misalignment and emphasize interest rate
differentials and productivity differentials as determinants of the real exchange rate.
An examination of the currency crises in the transition economies also argues for adopting
the Edwards-Williamson definition of the equilibrium real exchange rate and specifying it as a
function of macroeconomic fundamentals. Chapman and Mulino (2000), Chiodo and Owyang
(2002), Desai (2000) and Kharas, Pinto and Ulatov (2001) argue that the Russian crisis has
features in common with “first generation” models emphasizing policy inconsistencies.9 The
collapse of the Ruble in August 1998 appeared to be caused by exogenous factors related to the
unanticipated financial crisis in Asia, inappropriate fiscal policy and capital inflows. Karfakis
and Moschos (2004) conclude that macroeconomic fundamentals played a significant role in
explaining speculative attacks in Poland and the Czech Republic. Dobrinsky (2000) examines the
currency crisis in Bulgaria emphasizing historic roots, the evolution of fiscal, banking and
currency crises, and the political economy of the transition in Bulgaria while Chionis and
Liargovas (2003) argue that deteriorating fundamentals underlie the currency crises in Bulgaria,
Romania, Russia, and Ukraine.10
Overall, the literature indicates deteriorating fundamentals and inconsistent fiscal policies
have played an important role in the currency crises in Russia and Eastern Europe. Therefore,
when examining the determinants of the real equilibrium exchange rate, the role of the exchange
rate regime, measuring exchange rate misalignment and determining whether or not
9 “First generation” models, beginning with Krugman (1979), explain currency crises in terms of macroeconomic
policy inconsistencies. “Second generation” models, Obstfeld (1994, 1996), Eichengreen, et al. (1996a, 1996b)
emphasize herd behavior and self-fulfilling expectations. In “third generation” models moral hazard takes on a
central role (McKinnon and Pill (1996), inter alia). See Krugman (2000) and Sarno and Taylor (2002).
10 Liargovas (1999) also provides an excellent assessment of the factors, mainly macrofundamentals, influencing
real exchange rate movements in Eastern and Central Europe in the early 1990s.