presented in section 9, would not forecast a currency crisis. Section 10 provides a summary and
conclusions.
2. Exchange Rate Misalignments and Currency Crisis
Real exchange rate misalignment is defined as the difference between the long run
equilibrium real exchange rate and the prevailing real exchange rate. However, measurement of
the equilibrium real exchange rate is difficult since it is generally unobservable. A common
approach to such measurement begins with the notion of purchasing power parity (PPP).6 In the
analysis of transition economies this approach is problematic since an equilibrium period is
difficult to identify and productivity and other transition shocks may cause significant changes in
the equilibrium real exchange rate. Despite the weaknesses of the PPP approach it has been
employed by Barlow and Radulescu (2002), Barlow (2003) and Christev and Noorbakhsh (2000)
with mixed results. The real exchange rate is compatible with purchasing power parity in some
countries in certain time periods, but not consistently.
Further there were many factors at work during the transition period not typically
included in either the absolute or relative PPP model. For example, productivity growth
differentials were found to be an important determinant of the exchange rate by Richard and
Tersman (1996), Balazs (2002), de Broeck and Slok (2001) Halpern and Wyplosz (1997) and
6 A representative bundle of goods should cost the same regardless of currency and country (the ‘law of one price’
or perfect commodity arbitrage holds) and the absolute ‘purchasing power parity exchange rate’ between any two
currencies is the one that ensures the bundle of goods has the same price across countries. In reality this rate is not
likely to prevail because of differences in representative commodity bundles, transportation costs, tariffs and other
barriers to trade, imperfect or incomplete markets, and imperfect information, inter alia. If these factors are held
constant and a period in which the economy is at equilibrium can be identified, the notion of relative purchasing
power parity defines the equilibrium real exchange rate in the current period as the rate observed in the equilibrium
period, adjusting for the cumulative inflation differential since that time (Williamson, 1994).