Real exchange rate misalignment--the occurrence of a sustained departure of the actual real exchange rate from its equilibrium value--has been a recurring policy problem in many developing countries. A well-known difficulty associated with implementing policies designed to reduce real exchange rate misalignment is that of gauging the degree to which an exchange rate is out of equilibrium and, in some cases, the direction of misalignment. This is because information about the extent of misalignment requires knowledge of the level of the equilibrium real exchange rate, which depends on a host of structural and macroeconomic factors that may be difficult to measure.
Economists have frequently used information from the parallel foreign exchange market to gauge the extent of real exchange rate misalignment. The existence of a premium on foreign exchange in the free market is taken as indicative of an excess demand for foreign exchange at the official exchange rate, which in turn is interpreted as arising from an overvaluation of the domestic currency at the prevailing official exchange rate.
This paper argues that, from an analytical standpoint, the case for treating the size of the parallel market premium as an indicator of the magnitude of real exchange rate misalignment is not obvious. Both the premium on foreign exchange in the free market and the real exchange rate in the official market are endogenous variables with complex macroeconomic roles, and, as such, the correlation between them should depend in general on the sources of shocks impinging on the economy. Moreover, the parallel market premium is an asset price, which can be expected to exhibit much greater volatility than the official real exchange rate, in particular by responding to transitory shocks that leave the equilibrium real exchange rate unaffected. The very different time series properties of these two variables raise some doubt about the reliability of the premium as an indicator of real exchange rate misalignment.
This paper investigates how, in a developing country modeled along fairly standard lines, the parallel market premium and the real exchange rate jointly respond to some illustrative shock, taken to be a permanent productivity disturbance. The analysis suggests that the informational content of the premium may be limited because, in response to a shock, the premium will at various times along the adjustment path be positive and negative, whereas the degree of overvaluation of the currency is always positive for a negative shock and negative for a positive shock. The policy implication is that by itself the premium is not always a reliable indicator of real exchange rate misalignment. Other variables, including the various accounts of the balance of payments, may provide more reliable information.