Real Exchange Rate Misalignment: Prelude to Crisis?



currency or banking system management problems. We then 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?

We begin with a popular model of long run equilibrium real exchange rate determination
applied to developing economies by Elbadawi (1994). The model, based upon earlier work by
Dornbusch (1974) and Rodriguez (1989), specifies the long run equilibrium exchange rate as a
function of ‘sustainable’ or ‘permanent’ values of the macroeconomic fundamentals, such as the
terms of trade, net capital inflows, government expenditure and the respective governments’
openness to free trade,
inter alia. We then estimate short run movements of the real exchange
rate in an error correction model using GARCH estimation procedures. The responses to
exogenous shocks are calculated and we find that the real exchange rate returns to equilibrium
much faster in Poland than for Russia. In the pre-crisis period in Russia an exogenous shock
takes twice as long to correct as that in Poland, because in Poland the real exchange rate adjusts
to the shocks by changes in both the nominal exchange rate and the foreign and domestic price
levels. Whereas in Russia the nominal exchange rate is relatively rigid (in the pre-crisis period).
Misalignments are calculated as the short run deviations of the real exchange rate from the long
run equilibrium values. For Poland, the misalignments in the real exchange rate are relatively
small and decline as the nominal exchange rate regime becomes more flexible. The average



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