Real Exchange Rate Misalignment: Prelude to Crisis?



Appendix

For both countries data on the real effective exchange rate are from International Financial
Statistics (IFS). Terms of trade, TOT, is the ratio of the price of exports to the price of imports.
For Poland, the terms of trade data for import and export prices were obtained from International
Financial Statistics (IFS). For Russia, however, data on export prices and import prices were not
available. Therefore, a proxy employing available data was constructed:

PTOT = (EX/FGDP)/(IM/GDP),

where EX is real exports, GDP is nominal GDP, IM is nominal imports, and FGDP is the sum of
the real GDP’s of the top five major export recipients. The rationale for this is that for given
tastes and preferences, in equilibrium, the volumes of export and import are determined by the
terms of trade, GDP of the home country, and GDP’s of the export recipients. The relationship
between terms of trade and PTOT depends on the relative strengths of the income effect and
substitution effect on exports and imports. An increase in the terms of trade increases domestic
purchasing power and the domestic demand for goods in general, some of which are imports.
This increase in imports reflects an income effect. In addition, consumers shift from the
consumption of exportables and non-traded goods to the consumption of imports. Producers
increase the production of exportables and decrease the production of non-tradables. Generally
the income effect and the substitution effect in consumption dominate the substitution effect in
production and we expect a negative relationship between the terms of trade and PTOT. Further
the value of PTOT remains more or less stable with respect to changes in GDP and FGDP. This
is due to the fact that imports are a positive function of GDP, and hence, the import shares
(EX/FGDP & IM/GDP) do not change significantly with respect to changes in the respective
GDP’s. For regression purposes, the negative of logarithm of PTOT was considered.

43



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