1. Introduction
The role of the real exchange rate in the macroeconomic adjustment mechanism is of central
importance in many debates on economic development, growth strategies and stabilization
policies. Dornbusch (1982) and Williamson (1985), inter alia, discuss the effects of real
exchange rate misalignments on macroeconomic stabilization2 and following Edwards (1994),
there is a consensus that persistent misalignments of the real exchange rate imply serious
macroeconomic imbalances. Economies with fixed or less than flexible nominal exchange rate
regimes without foresight and suitable policies on the part of the government are subject to real
exchange rate misalignment that may have disastrous consequences. Accordingly, a successful
development strategy for a less developed economy or emerging market economy should include
efforts to maintain the real exchange rate at or near the ‘equilibrium’ level regardless of
exchange rate regime. Nonetheless, Asia and Latin America have suffered exchange rate and
related banking crises, which have been studied extensively,3 and several of the transition
economies of Eastern Europe and the former Soviet Union have experienced similar problems.
Here we examine the implications of the exchange rate regimes of two transition economies,
Russia which had a peg or less flexible managed exchange rate regime and experienced a
currency and banking crisis in August 1998, and Poland which had a more flexible managed or
freely floating exchange rate regime with better macroeconomic performance and virtually no
2 Harberger (1986) and Dervis and Petri (1987) discuss the relationship between real exchange rates and
economic performance. Serven and Solimano (1991) found that the stability of the real exchange rate has a positive
effect on private investment. Edwards (1986a, 1986c), Edwards and Van Wijnbergen (1986, 1987), Mussa (1974,
1978) and Pinto (1988) show the relevance of the real exchange rate to export promotion and generation of optimal
output and employment in behavioral models.
3 Agenor, Bhandari and Flood (1992), Aghion, Bacchetta and Banerjee (2000),
Berg and Pattillo (1999a, 1999b), Eichengreen, Rose and Wyplosz (1996), Frankel and Rose (1996), Goldstein,
Kaminsky and Reinhart (2000), Kamin and Babson (1999),Kaminsky, Lizondo and Reinhart (1998), Kaminsky and
Reinhart (1998, 1999),Krugman (2000), Obstfeld(1994,1996), and Reagle and Salvatore (2000) are representative
papers.