misalignment may be an indicator of impending crises, a model of exchange rate determination
based on macrofundamentals should be the starting point.
3. Exchange Rate Determination
Economists concerned with developing countries, small open economies, often use
theoretical models that involve the internal real exchange rate, the relative price of traded goods
to non-traded goods produced in the domestic economy:
ei = PT/ PN , (1)
where PT is the domestic currency price index of traded goods and PN is the domestic currency
price index of non-traded goods. 11 This, the ‘dependent economy’ definition of the real
exchange rate, is the internal relative price of producing and consuming traded goods at the cost
of non-traded goods. In a developing or emerging market economy where growth of the traded
goods sector relative to the non-traded goods sector is crucial to development,12 the internal real
exchange rate is an important indicator of the incentive to reallocate domestic resources, and a
useful device to capture Balassa-Samuelson effects explicitly13 For these reasons this definition
has been adopted or referred to for transition economies (Barlow (2003), De Boroeck and Slok
(2000), Egert, et al (2003), Kemme and Teng (2000), Kemme and Roy (2003), Liagrovas (1999),
Graffe and Wyplosz (1999), inter alia) which are opening to the world economy and
11 See Montiel and Hinkle (1999) and Hinkle and Nsengiyumva (1999)
12 See Hinkle and Nsengiyumva (1999). This definition was utilized by Dornbusch (1973, 1982), Devarajan,
Lewis, and Robinson (1993), Edwards (1989, 1994), Elbadawi (1994), inter alia for developing economies.
13 When productivity increases in the traded goods sector, demand for labor and thus wage rates increase. This
raises labor costs and prices in the non-traded goods sector. Hence, the real exchange rate appreciates. See Egert, et
al (2003) for a recent application analysis of the Balassa Samuelson effect in Central and Eastern Europe.
10
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