experiencing significant growth in traded goods relative to non-traded goods.14 Thus, in this
context the long run equilibrium real exchange rate is the relative price of tradables to
nontradables which, for given sustainable values of other relevant variables such as taxes,
international terms of trade, commercial policy, capital and aid flows and technology, results in
the simultaneous attainment of internal and external equilibrium.15
A major drawback to using the internal exchange rate is data availability. Data on prices of
tradable and non-tradable goods are not readily available, and therefore for the purpose of
empirical analysis, the external real exchange rate is used as a proxy for the internal real
exchange rate.16 It is defined as the nominal exchange rate adjusted for differences in price
levels, i.e. the ratio of the aggregate foreign price level to the home country’s aggregate price
level, measured in terms of a common currency. Thus, the external real exchange rate is
ee = E ( Pf/ Pd) , (2)
where E is the nominal exchange rate, defined as the domestic price of the foreign currency, and
Pf and Pd are the foreign and domestic aggregate price indexes, respectively. In most empirical
analysis the inverse of equation (1) is considered the internal real exchange rate and this is
proxied by the inverse of the external exchange rate, equation (2), for measurement purposes.
Therefore, we also use this as our definition of the exchange rate henceforth.
14 Graffe and Wyplosz (1999) develop a model to explain the trend currency appreciation and the weak link
between nominal exchange rate movements and real exchange rate movements in transition economies which
focuses on the traded goods - non-traded goods sectors and the decline in the state sector. Liargovas (1999) adopts
the definition and in Table 1 presents a nice summary of factors which have affects on the real exchange rate in the
case of a small country with traded and non-traded goods. De Broeck and Slok (2001) use a traded goods non-traded
goods framework to show that for EU accession countries there is strong evidence of productivity-based exchange
rate movements.
15 Again, from Edwards (1989). Internal equilibrium is a condition where the market for non-tradable goods
clears or is expected to clear in current and future periods. External equilibrium is attained when current and future
current account balances and long-run sustainable capital flows are consistent with each other.
16 See Hinkle and Nsengiyumva (1999) for the exact relationship between the two definitions.
11