1

ACADEMY OF ECONOMIC STUDIES

DOCTORAL SCHOOL OF FINANCE AND BANKING

Dissertation Paper

The Equilibrium Real Exchange Rate

(An Empirical Analysis on the

USD/ROL exchange rate)

Student: Cristina Maria Iacob

Supervisor: Professor Moisă Altăr

2

CONTENTS

•Literature review

•The concept of Equilibrium Real Exchange Rate (ERER) and its importance

•The model

•The data

•Estimating the ERER and the degree of misalignment

•Concluding remarks

3

LITERATURE REVIEW

• The FEER approach

Williamson (1985, 1994): the ERER is calibrated at a

level consistent with both internal and external balance.

• The BEER approach

P.Clark and R.MacDonald (1997,1998,2001)

J.Baffes, I.A.Elbadawi, S.A.O’Connell (1997)

T.Feyzioglu (1997)

L.Halpern and C.Wyplosz (1996,1998,2001)

B.Egert (2001), B.Y. Kim and I.Korhonen (2002)

a two-step procedure: a simple behavioral ERER relationship is estimated and then this is used to determine the misalignment.

4

THE CONCEPT OF ERER

• The PPP TheoryThe PPP Theory: the exchange rate should be driven only by the

level and movement of the prices in the two countries;

-the wrong rule to follow by transition economies (lack of historical data; non-conventional factors ).

•The Equilibrium Real Exchange RateThe Equilibrium Real Exchange Rate is the level of the real

exchange rate when internal (equilibrium in the non-tradable

market) and external (sustainability of long-term capital flows)

balances are achieved.

5

THE IMPORTANCE OF ERER

External competitivenessExternal competitiveness:

• overvalued currency: high export prices, loss of competitiveness;

•in transition economies (reduced output and high unemployment) export-led growth argues in favor of slightly undervalued exchange rates.

Joining the EU and adopting the EuroJoining the EU and adopting the Euro:

•ERM2: an undervalued currency is susceptible to experience inflationary pressure in the process of real appreciation (fail to meet the Maastricht convergence criterion on inflation).

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THE ROMANIAN ECONOMY

•The NBR’s objective: to assure currency stability in order to maintain price stability.

•Managed float exchange rate regime.

•19971997: foreign exchange market liberalization; the last stage of price liberalization high jump in inflation and nominal depreciation.

•19991999: peak of the due payment of external debt balance of payment crisis (the country didn’t enter payment incapacity).

•High liberalization of the capital account.

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THE REAL EXCHANGE RATE USD/ROL (1995-2002)

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

95 96 97 98 99 00 01 02

RER

•The beginning of transition: real depreciation.

•This is followed by real appreciation driven not by increases in productivity, but by a “natural recovery” process.

•1997: nominal depreciation and higher inflation real appreciation.

•1999: nominal and real depreciation.

•2001: real appreciation followed by nominal appreciation

RO

USA

tt CPI

CPINERRER *

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THE MODEL (S.Edwards (1989) and Montiel (1996))

•A small, open economy based on two sectors.

•Maximizing utility households: .

•The dynamic budgetary constraint:

•The public sector:

•Internal balance:

•External balance:

dtptCC

MaxNTT

)exp(1

1

])()[( /11)1(

])()*[(][ tDt

Fttttt MiBiBdiTCYBC

][][ NTTG GGMBiTBC

NTNTNT GCRERY )(

TT GCNFAiRERYNFA )*(*)(*

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THE DATA

•Internal balance: CREDIT (non-governmental), DEP (difference between foreign currency and ROL deposits);

•External balance: NFA (net foreign assets to GDP), OPEN (exports plus imports to GDP);

•GDP proxied by the index of industrial output

0.2

0.4

0.6

0.8

1.0

1.2

1.4

95 96 97 98 99 00 01 02

CREDIT

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

95 96 97 98 99 00 01 02

DEP

-1

0

1

2

3

4

5

6

7

8

95 96 97 98 99 00 01 02

NFA

0.8

1.2

1.6

2.0

2.4

2.8

95 96 97 98 99 00 01 02

OPEN

•Real indeces (CPI deflated), fixed base January 1995=100;•Monthly data•Source: NBR Annual Reports

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THE GOAL

ttttt DEPCREDITOPENNFARER 4321

To estimate the equilibrium real exchange rate as:

•Cointegration technique (Johansen, Engle-Granger)

- + +/- +

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DECOMPOSING REAL AND NOMINAL

EXCHANGE RATE MOVEMENTS

•VAR analysis (Blanchard and Quah decomposition) on the log of the real and nominal exchange rate (I(1)).

•The restriction:nominal shocks have no long-run effect on the RER

Period S.E. Shock1 Shock2

1 0.036165 67.48620 32.51380 2 0.038611 59.80341 40.19659 3 0.040384 55.37500 44.62500 4 0.041393 53.50156 46.49844 5 0.041750 53.69020 46.30980 6 0.041984 53.09377 46.90623 7 0.042203 52.55498 47.44502 8 0.042250 52.56309 47.43691 9 0.042256 52.57514 47.42486

10 0.042258 52.57079 47.42921

Variance Decomposition

•The importance of nominal shocks (due to NBR’s interventions)

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ESTIMATING THE ERER

• Unit root tests

Variable ADF PP

RER C I(1) C I(1)NFA TC I(1) TC I(1)OPEN C I(1) C I(1)CREDIT C I(1) C I(1)DEP C I(1) C I(1)

1% significance level;

the unit root tests are biased towards accepting the null of a unit root in the presence of structural breaks .

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ESTIMATING THE ERER

•VAR analysis

-.03

-.02

-.01

.00

.01

.02

.03

.04

.05

1 2 3 4 5 6 7 8 9 10

Response of RER to OPEN

-.03

-.02

-.01

.00

.01

.02

.03

.04

.05

1 2 3 4 5 6 7 8 9 10

Response of RER to NFA

-.03

-.02

-.01

.00

.01

.02

.03

.04

.05

1 2 3 4 5 6 7 8 9 10

Response of RER to DEP

-.03

-.02

-.01

.00

.01

.02

.03

.04

.05

1 2 3 4 5 6 7 8 9 10

Response of RER to RER

-.03

-.02

-.01

.00

.01

.02

.03

.04

.05

1 2 3 4 5 6 7 8 9 10

Response of RER to CREDIT

Response to Cholesky One S.D. Innovations ± 2 S.E.

Variables in levels, 2 lags;

Impulse response functions:

),,,,( CREDITRERDEPNFAOPENRER + - + + +

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ESTIMATING THE ERER

•Johansen cointegration test

Unrestricted Cointegration Rank Test

Hypothesized Trace 5 Percent 1 PercentNo. of CE(s) Eigenvalue Statistic Critical Value Critical Value

None ** 0.323500 84.59244 68.52 76.07At most 1 * 0.269719 47.85512 47.21 54.46At most 2 0.147632 18.30846 29.68 35.65At most 3 0.033284 3.293207 15.41 20.04At most 4 0.001183 0.111299 3.76 6.65

*(**) denotes rejection of the hypothesis at the 5%(1%) level Trace test indicates 2 cointegrating equation(s) at the 5% level Trace test indicates 1 cointegrating equation(s) at the 1% level

Hypothesized Max-Eigen 5 Percent 1 PercentNo. of CE(s) Eigenvalue Statistic Critical Value Critical Value

None * 0.323500 36.73732 33.46 38.77At most 1 * 0.269719 29.54666 27.07 32.24At most 2 0.147632 15.01525 20.97 25.52At most 3 0.033284 3.181908 14.07 18.63At most 4 0.001183 0.111299 3.76 6.65

*(**) denotes rejection of the hypothesis at the 5%(1%) level Max-eigenvalue test indicates 2 cointegrating equation(s) at the 5% level Max-eigenvalue test indicates no cointegration at the 1% level

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ESTIMATING THE ERER

Johansen cointegrating relation:

RER=0.021297+0.538429*OPEN-0.068865*NFA+0.038304*DEP+ (0.07563) (0.01741) (0.04866)

+0.298500*CREDIT (0.04610)

-.3

-.2

-.1

.0

.1

.2

.3

95 96 97 98 99 00 01 02

Cointegrating relation

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ESTIMATING THE ERER

Engle-Granger cointegrating relation:

RER=0.356169-0.053560*NFA+0.131087*OPEN+0.193242*DEP+ (0.048655) (0.005841) (0.031664) (0.015865) +0.320477*CREDIT (0.022323)

-.12

-.08

-.04

.00

.04

.08

.12

95 96 97 98 99 00 01 02

The cointegrating relation (stationary residuals:ADF and PP)

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ESTIMATING THE ERER

The estimated ERER

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

95 96 97 98 99 00 01 02

ERER_MODEL1 RER

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

95 96 97 98 99 00 01 02

ERER_MODEL2 RER

Fitted ERER on the Johansen equilibrium relationship

Fitted ERER on the Engle-Grangerequilibrium relationship

•The estimated ERER will allow us to determine the misalignment of the exchange rate.

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SHORT-RUN DYNAMICS

VEC representation:

D(RER) = - 0.32354355*( RER(-1) - 0.5384287381*OPEN(-1) + +0.06886480321*NFA(-1) - 0.03830424481*DEP(-1) - 0.2985004165*CREDIT(-1)

- 0.02129682639 ) - 0.06856552318*D(RER(-1)) - 0.107401684*D(OPEN(-1)) - 0.004766388211*D(NFA(-1)) + 0.06294160197*D(DEP(-1)) +

+0.09737686503*D(CREDIT(-1)) + 0.0008867915601

•The time required to dissipate x% of a shock in the RER:)1()1( xt

α = the absolute value of the speed of adjustment

the time it takes for the RER to come to equilibrium after a 1% shock , is 0.0257550.025755 years or 9.2729.272 days.

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WEAK-EXOGENEITY TESTS

Variable 2 p-value

RER 6.7427390.009415OPEN 6.9529510.008368NFA 1.9671420.160752DEP 0.0970680.755377CREDIT 4.9815080.025620

• The NFA and the proxi for the demand of foreign currency (DEP) are weakly exogenous.

• OPEN and CREDIT accomodate to RER disequilibrium.

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STABILITY TESTS

-30

-20

-10

0

10

20

30

1996 1997 1998 1999 2000 2001 2002

CUSUM 5% Significance

-60

-50

-40

-30

-20

-10

0

10

20

30

1995 1997 1998 1999 2000 2001 2002

CUSUM 5% Significance

The CUSUM test on the VEC representation of the Johansen equilibrium relationship

The CUSUm test on the Engle-Granger estimated equilibrium relationship

• Only the Johansen estimated equilibrium relationship has stable coefficients over the whole sample.

•The second relation is not stable.

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EXCHANGE RATE ACTUAL MISALIGNMENT

-.3

-.2

-.1

.0

.1

.2

.3

95 96 97 98 99 00 01 02

Actual misalignment

-.12

-.08

-.04

.00

.04

.08

.12

95 96 97 98 99 00 01 02

Actual misalignment

0

2

4

6

8

10

12

14

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-0.2 -0.1 0.0 0.1 0.2

Series: MISALIGNMENT1Sample 1995:01 2002:12Observations 96

Mean 8.91E-06Median 0.002928Maximum 0.248577Minimum -0.198825Std. Dev. 0.088332Skewness 0.090501Kurtosis 3.192871

Jarque-Bera 0.279844Probability 0.869426

0

2

4

6

8

10

-0.10 -0.05 0.00 0.05 0.10

Series: MISALIGNMENT2Sample 1995:01 2002:12Observations 96

Mean -9.36E-07Median 0.003983Maximum 0.093831Minimum -0.109777Std. Dev. 0.049927Skewness -0.278627Kurtosis 2.243987

Jarque-Bera 3.528352Probability 0.171328

Model 1:

On average, the national currency was undervalued

Model 2:

On average, the national currency was overvalued

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EXCHANGE RATE TOTAL MISALIGNMENT

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

95 96 97 98 99 00 01 02

MODEL1 MODEL2 RER

-.2

-.1

.0

.1

.2

.3

.4

.5

95 96 97 98 99 00 01 02

Total misalignment

-.2

-.1

.0

.1

.2

.3

.4

.5

95 96 97 98 99 00 01 02

Total misalignment

Estimated ERER based on the long-run value of the fundamentals vs. the actual RER

Total misalignment for Johansen equilibrium relation

Total misalignment for Engle-Granger equilibrium relation

• Total misalignment includes the departure from equilibrium of the fundamentals, too.

•Model 1undervaluation of the national currency.

•Model 2overvaluation of the national currency.

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THE MODEL’S FORECAST ABILITY

•The VEC representation of the first model the one step ahead forecast of the real exchange rate:

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

95 96 97 98 99 00 01 02

RER fitted RER actual

•The model yields a reasonable approximation of the real exchange rate for the period 1995:01-2002:12

•It reveals an overvaluation of the national currency during the second half of 2002

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CONCLUSIONS

•Nominal factors (monetary policy) play an important role in exchange rate determination.

•The undervaluation of the national currency improves the external competitiveness and favorizes export-led growth.

•Further analysis should determine the EUR/ROL ERER.

•The managed float regime is more suitable than a fixed regime.

•The results are determined by the choice of fundamentals.

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REFERENCES

Baffes,J., I.A. Elbadawi, and S.A.O’Connell, (1997) “Single-equation estimation of the equilibrium real exchange rate” ,World Bank Working Paper No. 08/20/97;Chinn, M. (1997), “ Sectoral productivity, government spending and real exchange rates: empirical evidence for OECD countries”, NBER working paper 6017;Chinn,M., and L.Johnston (1996), “Real exchange rate levels, productivity and demand shocks : evidence from a panel of 14 countries”, NBER working paper 5709;

Clarida,R. and J. Gali (1994), “ Sources of real exchange rate fluctuations: how important are nominal shocks?”, NBER working paper 4658;

Clark,P.B. and R.MacDonald (1998) “Exchange rates and economic fundamentals: A methodological comparison of BEER’s and FEER’s “, IMF working paper 9867;DeBroeck,M. and T.Slok (2001), “Interpreting real exchange rate movements in transition countries”, BOFIT Discussion Paper 7.

DeGregorio,J., and H.C. Wolf (1994) “Terms of trade, productivity and the real exchange rate”, NBER working paper 4807

Edwards,S. (1989) “Real and monetary determinants of real exchange rate behavior: theory and evidence from developing countries”, NBER working paper 2721;Egert, B. (2001a) “Equilibrium real exchange rates in central Europe’s transition Economies: How far is heaven?”, University of Paris X- Nanterre;(2001b) “ Estimating the impact of the Balassa-Samuelson effect on inflation during the transition: does it matter in the run-up to EMU?”, Paper presented at the “East European Transition and EU Enlargement: a Quantitative Approach” meeting in Gdansk; Enders,W. (2000), “Applied Econometric Time Series”, in John Wiley & Sons.

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Engle, R. and C.Granger (1987), “Cointegration and Error-Correction: Representation, Estimation and Testing”, Econometrica 55, 251-276;

Faust,J. and J.Rogers (1999), “ Monetary Policy’s Role in exchange rate behavior”, Board of Governors of the Federal System, International Finance Discussion Papers No 652;Feyzioglu,T. (1997), “Estimating the equilibrium real exchange rate : an application to Finland”, IMF working paper WP/97/109;

Gardeazabal,J., M. Regulez, and J. Vasquez (1997), “ Testing the canonical model of exchange rates with unobservable fundamentals”, International Economic Review;Grafe,C. and C. Wyplosz (1997) “The Real exchange rate in transition economies”, Paper presented at the Third Dubrovnik Conference On Transition Economies in Dubrovnik, Croatia;Greene, W.H. (2000), “Econometric Analysis”, Prentice Hall International, Inc.Halpern,L. and C. Wyplosz (1997a) “Equilibrium Exchange rates in transition economies”, IMF staff working paper 44, 430-461;(1998b), “Equilibrium exchange rates in transition economies: further results”, prepared as part of a CEPR project on "Equilibrium and Adjustment Dynamics of the Exchange Rates of the Associated Countries of Central and Eastern Europe"; (2001c) “Economic Transformation and real exchange rates in the 2000’s : the Balassa-Samuelson Connection”, UNECE working paper;Kim, B.Y and I. Korhonen (2002), “Equilibrium exchange rates in transition countries: Evidence from dynamic heterogeneous panel models”, BOFIT Discussion Paper 15;Kocenda, E. (1998), “Detecting structural Breaks: exchange rates in transition economies”, W. Davidson Institute at the University of Michigan Business School,CEPR, London;

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Kutan,A.M. and S. Dibooglu (1998), “Sources of real and nominal exchange rate fluctuations in transition economies”, The Federal Reserve Bank of St Louis, working paper 1998-022A;Lastrapes,W.D. (1992), “Sources of fluctuations in real and nominal exchange rates”, The review of economics and statistics, Volume 74, Issue 3, 530-539.

MacDonald, R. (1997a) “What determines the real exchange rate? The long and short of it”, IMF working paper WP/97/21;(2001b), “Modelling the long-run real effective exchange rate of the New Zealand Dollar”, Reserve Bank of New Zealand, DP2002/02;

Rault,C. and I. Drime (2001), “Long run determinants of real exchange rates:new evidence based on panel data unit root and cointegration tests for MENA countries”, EUREQUA, Sorbonne University;

Rogers,J. (1998), “Monetary Shocks and real exchange rates”, Board of Governors of the Federal System, International Finance Discussion Papers number 612;

Wyplosz, C. (1999) , “Ten Years of transformation: macroeconomic lessons”, Paper presented at the World Bank Annual Bank Conference on Development Economics, Washington;*** National Bank of Romania- Annual Reports 1995-2002*** National Bank of Romania- Monthly Bulletins 1995-2002