capital inflows in the pre-crisis period. This was accompanied by domestic inflation and real
appreciation of the exchange rate. However, around the time of the August 1998 crisis, all
transition economies experienced capital flow reversals along with a depreciation of the
respective real exchange rate. The openness of the economy, OPEN, is negative and statistically
significant for both countries. The implication is that trade liberalization may not be viable
without currency depreciation. The share of government expenditure in GDP, GOV, is
statistically significant for both Poland and Russia. A priori the sign may be either positive or
negative. And indeed it is positive for Russia, but negative for Poland. During this period GOV
exhibits a downward trend and the real exchange rate has an upward trend in both countries.
This implies that government expenditures in Russia were biased toward non-tradables and as
GOV falls, expenditures on non-traded goods falls faster than expenditures on tradables and
therefore the price of non-tradables falls faster than the price of tradables and the real exchange
rate decreases as GOV decreases (or increases as GOV increases). The opposite occurs in Poland
if government expenditures are biased toward traded goods.
6. Short Run Exchange Rate Estimates
In Tables 7 and 8 the error correction equations are presented. ∆(.) denotes the first
difference of the relevant variable, and the p-value is in parentheses beneath each coefficient.
These equations describe short run changes in the real exchange rate as a function of short run
changes of the relevant fundamentals, TOT, FLOW, OPEN and GOV, other exogenous
variables, DCRE and NEER, and the error correction term, EC(-1), the difference between the
actual real exchange rate and the estimated long-run real exchange rate, one period lagged.
Specification 1 is the initial specification, with some coefficients statistically insignificant. For
27