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Assessing the Real Exchange Rate Misalignments: Is Real Undervaluation of the Currency Likely and Can It Be Sustained?

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  • Megumi Kubota

Abstract

There is a renewed debate on the role of exchange rate policies as industrial policy tools in both academic and policy circles. Policy practitioners usually examine real exchange rate (RER) misalignments to monitor the behavior of this key relative price and, if possible, exploit distortions in the traded and non-traded relative price to promote growth. Anecdotal evidence shows that some countries have pursued very active exchange rate policies to promote the export sector and enhance growth (e.g. China) by undervaluing their currencies. The main goal of this paper is to provide a systematic characterization of real exchange rate undervaluations. We first calculate fundamental RER misalignments based on the long run RER equation derived from the theoretical model developed by Kubota (2009). Then, we construct a dataset of real undervaluation episodes. Second, we present some basic evidence on the co-movement of RER undervaluation and (real and nominal) macroeconomic aggregates. We specifically assess the behavior of macro aggregates during undervaluations using an “event analysis” methodology. Finally, we evaluate whether (and if so, to what extent) economic policies can be used to either cause or sustain real undervaluations. In this context we empirically model the likelihood and magnitude of sustaining RER undervaluations by examining their link to policy instruments (e.g. exchange rate regimes, capital controls, among other policies) using Probit and Tobit models, respectively.

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Paper provided by Department of Economics, University of York in its series Discussion Papers with number 09/25.

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Handle: RePEc:yor:yorken:09/25

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  1. Megumi Kubota, . "Real Exchange Rate Misalignments: Theoretical Modelling and Empirical Evidence," Discussion Papers 09/24, Department of Economics, University of York.
  2. Ricardo Hausmann & Lant Pritchett & Dani Rodrik, 2004. "Growth Accelerations," NBER Working Papers 10566, National Bureau of Economic Research, Inc.
  3. Lane, Philip R. & Milesi-Ferretti, Gian Maria, 2007. "The external wealth of nations mark II: Revised and extended estimates of foreign assets and liabilities, 1970-2004," Journal of International Economics, Elsevier, vol. 73(2), pages 223-250, November.
  4. Lane, Philip R. & Milesi-Ferretti, Gian Maria, 2001. "The external wealth of nations: measures of foreign assets and liabilities for industrial and developing countries," Journal of International Economics, Elsevier, vol. 55(2), pages 263-294, December.
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  7. Philip R. Lane & Gian Maria Milesi-Ferretti, 2008. "The Drivers of Financial Globalization," American Economic Review, American Economic Association, vol. 98(2), pages 327-32, May.
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  12. Vahagn Galstyan & Philip R. Lane, 2009. "The Composition of Government Spending and the Real Exchange Rate," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(6), pages 1233-1249, 09.
  13. Lane, Philip R. & Milesi-Ferretti, Gian Maria, 2000. "The Transfer Problem Revisited: Net Foreign Assets and Real Exchange Rates," CEPR Discussion Papers 2511, C.E.P.R. Discussion Papers.
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  15. Dollar, David, 1992. "Outward-Oriented Developing Economies Really Do Grow More Rapidly: Evidence from 95 LDCs, 1976-1985," Economic Development and Cultural Change, University of Chicago Press, vol. 40(3), pages 523-44, April.
  16. Frenkel, Jacob A. & Mussa, Michael L., 1985. "Asset markets, exchange rates and the balance of payments," Handbook of International Economics, in: R. W. Jones & P. B. Kenen (ed.), Handbook of International Economics, edition 1, volume 2, chapter 14, pages 679-747 Elsevier.
  17. Glick, Reuven & Hutchison, Michael, 2005. "Capital controls and exchange rate instability in developing economies," Journal of International Money and Finance, Elsevier, vol. 24(3), pages 387-412, April.
  18. M. Ayhan Kose & Kenneth Rogoff & Eswar Prasad & Shang-Jin Wei, 2003. "Effects of Financial Globalization on Developing Countries," IMF Occasional Papers 220, International Monetary Fund.
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