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This paper was written while I was a visiting scholar at the Research Department, International Monetary Fund. I would like to thank Peter Clark for many helpful discussions and comments on earlier drafts. I am also grateful to Robert Dixon for his comments.
Two recent theoretical studies of the cost of misalignment are: Huizinga (1997) on the political economy of import subsidies and Balwin and Lyons (1994) on the welfare cost of industrial dislocation.
The equilibrium rate has been variously described as the fundamental or the long run rate. For this study superscripts would be used to denote the various definitions – equilibrium (e); fundamental (f); long-run (l). Also, in keeping with the literature, the log form shall be used throughout.
This is an important requirement for efficient single-equation estimation and especially if the equation is to be used to generate counter-factual simulations.
Taken together, these references review various models of the real exchange rate from purchasing power parity, to more elaborate models which allows for determinants such as productivity, the terms of trade and net foreign assets.
In particular, these references discuss the related concepts of Fundamental Equilibrium Exchange Rate (FEER), Desirable Equilibrium Exchange Rate (DEER) and Equilibrium Real Exchange Rates (ERER).
Identification of the nature of the misalignment is particularly important for informed policy response because different reactions are required depending on whether the misalignment reflect the adjustment process of economic variables, policy variables or the disturbance term. For more discussion of types of policy reactions see Isard and Faruqee (1998) and references therein.
The limitation applies even in a dynamic setting. This is because, put simply, deviations in a cointegrated regression are, by construction, restricted only to short-run terms.
For an example using fractional integration to analyze the dynamics of misalignment see Lim and Wilkins (1998).
A point worth noting at the outset is that the target zone literature is also concerned with the relationship between interest differentials and realignment. This paper is about these relationships in a different context - that of long run and equilibrium relationships.
In the case of Thailand, the time-paths of q, s and (p − p*) show clearly that purchasing power parity does not hold. Also unit root tests of the real exchange rate show that it is an I(1) variable. For a survey of purchasing power parity, see Rogoff (1995).
Techniques of fractional integration and its associated impulse response functions may be used for this class of models, to understand better the nature of the dynamic path to equilibrium.
An alternative scenario is to assume a fixed exchange rate regime so that the assumed
The relationship between interest differentials, exchange rate variability and the credibility and reputation of policy makers is explored in Agenor and Masson (1999). See also, Caramazza (1993), Knot, Sturm and de Haan(1998) and Ros and Svensson (1994).
Based on information in the International Monetary Fund’s report on exchange arrangements for Thailand. Details about the extent of forward intervention by the Bank of Thailand in the months prior to the July crash can be found in theIMF’s September 1998 International Capital Markets Report, especially in Box 2.11.
Much has been written about the Asian currency crises, both on the lead-up to the crisis and the aftermath of the crisis, see for example the reviews by Corsetti, Pesenti and Roubini (1998 a, b) and the discussion in the International Monetary Fund, World Economic Outlook (1998) and references therein.
Other variables considered include: the log of the terms of trade defined as log (export price/import price); a log measure of the relative price of nontraded to traded goods defined as log (consumer price index/wholesale price index); a term to capture the influence of fiscal policy defined as (total government debt/nominal GDP). None of these variables were significant in the cointegrating equation.
This is the point where
See, Lim and Martin (1995) for an analysis of the relationships between regression-based cointegration estimators.
It has been argued that increases in net foreign debt are caused by current account deficits, and hence the real exchange rate should depreciate for equilibrium (positive relationship). In floating exchange rate regimes, this is probably true, but in managed regimes, capital flows can be the cause of an increase in foreign debt. For an analysis of the role of capital flows and currency crisis see, Milesi-Ferretti and Razin (1998).
Which is to say that the system was inherently self-correcting – as suggested by the cointegration relationship. However, that the inevitable realignment of the currency took the form of a dramatic crash was just one form of mean-reversion. If information about the misalignment had been discerned earlier, it may have been possible to engineer a series of progressive devaluations.