Real Exchange Rate Misalignment: Prelude to Crisis?

stationary or stationary in first differences and have short run effects on the real exchange rate.
D(F) captures the short run effects of the temporary components of the macroeconomic
fundamentals. γ₀, γ'₁ and γ'₂ are the corresponding parameter vectors to be estimated.

Equation (5) is useful in interpreting short run fluctuations and for forecasting purposes.
The error correction term is the short run forward-looking self-correcting mechanism. If there is
a real under-valuation in the current period, then the error correction term is negative. Hence, if
γ0 is negative, there will be a real appreciation in the next period, thereby self-correcting the
under-valuation. Similarly, if there is an overvaluation, the positive error correction term and the
negative γ0 will imply a real depreciation in the next period. The speed of such adjustments will
depend on the value of γ₀, with 0< ∣ γ₀| <1, and the closer the value is to 1, the faster the speed of
adjustment.

To specify F we follow Elbadawi (1994) and Montiel (1999b). The equilibrium real
exchange rate is determined by the equilibrium conditions in the traded goods and non-traded
goods markets described by a vector of fundamentals:

F = [log(TOT), log(OPEN), (FLOW), log(GOV)] ,                           (6)

( +/- )        (-)        (+)        (+/-)

where TOT is the terms of trade, OPEN is equal to the ratio of the sum of export and import to
GDP, a proxy for the country’s openness to trade, FLOW is the ratio of net capital inflows to
GDP, GOV is the ratio of total government expenditures to GDP. ¹⁸ The equilibrium real
exchange rate is then found by substituting the vector of the permanent values of the
macroeconomic fundamentals, F^pt, into equation (3) along with B, the estimates of β. The error

¹⁸ Elbadawi (1994) also includes the ratio of public expenditure on non-traded goods to total government
expenditure. However, since data on public expenditures on non-traded goods are not available, for estimation
purposes, he discards this variable. We also considered oil prices, but Rautava (2004), p. 325, found movements in
the Ruble real exchange rate were not affected by oil prices.

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