The sign of the coefficient of TOT in the long run equilibrium relationship is, therefore,
indeterminate.
An increase in net capital inflows is expected to raise the real exchange rate by increasing the
supply of foreign currency and putting inflationary pressure on the domestic market. Thus the
sign of FLOW is expected to be positive. As the openness of a country increases, with increased
supply of foreign goods the demand for non-traded goods is likely to fall, thereby decreasing the
real exchange rate. Hence, the expected sign for the OPEN variable is negative. To the extent
that government expenditure increases in the non-traded goods sector, it is expected to have a
positive effect on the real exchange rate by raising the price of the non-traded goods, and the sign
of GOV is positive. However, if the share of government spending on non-traded goods falls
even though government expenditure increases, then the real exchange rate is likely to decrease.
In the error correction equation, equation (5), the signs of both DCRE and NEER are
expected to be positive. An expansionary macroeconomic policy generates inflationary
pressures increasing the price of non-traded goods and the exchange rate. In the short run a
nominal devaluation will cause a real devaluation as well and the expected sign would be
positive.
Thus, equations (3), (4) and (5) with the vector of fundamentals given in (6), and the
additional variables in X, constitute the entire model for exchange rate determination. The
parameters, β, are estimated from equation (4). The long run equilibrium real exchange rate, eteq,
is found by substituting the permanent values of the fundamentals, Fp, and the estimates of β into
equation (3). Short run fluctuations in the exchange rate may be examined with equation (5),
also estimated after substituting the estimates of β. Then, misalignments are calculated as the
short run deviations of the exchange rate from the long run equilibrium value corresponding to
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