Real Exchange Rate Misalignment: Prelude to Crisis?

Executive Summary

In this paper we examine both short run and long run movements in exchange rates for
Poland and Russia. Specifically, we ask 1) can the long run equilibrium real exchange rate for a
transition economy be modeled with conventional tools? 2) is the error correction model
appropriate for explaining short run behavior of the real exchange rate in these economies? 3) do
different nominal exchange rate regimes generate explicitly different equilibrium relationships
and are the responses to exogenous shocks different? 4) given the appropriateness of the model
to what extent has there been real exchange rate misalignment in these two economies? and 5) to
the extent that the misalignment is persistent is it an effective indicator of a potential crisis? A
tradable goods non-tradable goods model based upon Elbadawi (1994) and earlier work by
Dornbusch (1973) and Rodriguez (1989) specifies the long-run equilibrium exchange rate as a
function of macroeconomic fundamentals, such as terms of trade, net capital inflow, government
expenditure and the respective governments’ openness to free trade. We estimate this model and
calculate the exchange rate misalignments for both currencies. To estimate the long run
equilibrium equation for the real exchange rate we start with the Engel Granger static OLS
procedure, and to correct for potential bias of the coefficients or endogeneity problems we use
dynamic OLS for the final specifications. . The number of co-integrating equations is confirmed
by the Johansen method and the statistical significance of the macroeconomic fundamentals on
the long run equilibrium values is assessed with the relevant statistical tests. Two important
findings are confirmed: the real appreciations in the transition economies are due to significant
net capital inflow (Brada, 1998; Drabek and Brada, 1998; Liargovas, 1999) and productivity
shocks (Richards and Tersman, 1996; Halpern and Wyplosz, 1997; Balazs, 2002; de Broeck and
Slok, 2001).

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