Real Exchange Rate Misalignment: Prelude to Crisis?



8. The Long Run Equilibrium Real Exchange Rates and Misalignments

Calculating the long run equilibrium real exchange rates require the permanent values of the
macro fundamentals. In many applications the trend component of a non-stationary time series is
taken as the permanent value. However, in some cases what may appear to be a ‘trend’, may in
fact be the accumulation of changes that are autocorrelated, having a mean value. To overcome
this limitation, Beveridge and Nelson (1981) provide an alternative method for decomposing a
time series into permanent and transitory or cyclical components using ARIMA models. The
advantage of this method is that at least part of the short run changes in any economic variable
can be attributed to changes in the equilibrium values. Cuddington and Winters (1987) suggest
an improvement that reduces the computational cost of the decomposition method, and their
approach is utilized in order to decompose the time series of the macroeconomic fundamentals
into permanent and transitory components.

The estimates of the long run equilibrium real exchange rates (eeq) are then obtained by
substituting the values of the permanent components into the estimated cointegrating equations
(specification 2 from Table 3 for Poland, and specification 2 from Table 4 for Russia). The
misalignments then are calculated as

M = log(e) - log(eeq),                                                                    (7)

where eeq is the long run equilibrium real exchange rate, e is the actual real exchange rate, and M
> 0 implies a currency overvaluation.

In Figure 4 the real exchange rate misalignments for both countries are plotted. Note that in
Russia there was a strong under-valuation of the currency in the very early years, followed by a
prolonged overvaluation in the pre-crisis period due to excessive net capital inflows and high
rates of inflation. It is also found that just around the time of the crisis, the speculative pressure

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