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I would like to thank Paul Cashin, Jean Le Dem, and Gabriel Sensenbrenner for helpful comments and suggestions, and Fernanda Sayavedra for excellent research assistance.
A constant real exchange rate rule, based on the notion of purchasing power parity, aims at keeping the real exchange rate constant at a level that prevailed in some base period, when macroeconomic balance was thought to obtain, see Dornbusch (1982) and Montiel and Ostry (1991).
Algeria’s exchange rate regime is a managed float with no pre-announced path for the exchange rate. Algeria’s main trading partners are: Austria, Belgium, Canada, China, France, Germany, Italy, Japan, the Netherlands, Spain, Switzerland, Sweden, Turkey, the United Kingdom, and the United States.
An increase in the REER is equivalent to a real appreciation.
See Balassa (1964) and Samuelson (1964). The Balassa-Samuelson effect is described as follows: if a country experiences an increase in the productivity of the tradables sector (relative to its trading partners), its real exchange rate would tend to appreciate. For given prices of tradables, such stronger productivity would induce higher wages in the tradables sector; if wages are equalized across sectors, this would be reflected into higher prices of nontradables, and, hence an increase in the consumer price index relative to trading partners.
The used data is the logarithm of the INS monthly REER for the period 1995:01-2004:06
These procedures will provide better results for larger numbers of observations.
The implied half-life of the shock to commodity-price- and productivity-augmented PPP is calculated as follows: the time (T) required to dissipate x percent (in this case, 50 percent) of a shock is determined according to (1-Θ)T = (1-x), where Θ is the coefficient of the error-correction term and T is the required number of periods (years).
The smoothed equilibrium real exchange rate in Figure 3 is derived by applying to the explanatory variables a Hodrick-Prescott filter with a smoothing factor of 100. This smoothing technique neutralizes the impact of temporary fluctuations in explanatory variables on the evolution of the equilibrium real exchange rate by deriving a proxy for the long run equilibrium values of these variables. This measure can therefore be defined as the level of the REER that is consistent in the long run with the equilibrium values of the explanatory variables.
The small gap between the equilibrium and the actual level of the REER at end-2003 could be due to temporary shocks not captured by the long-run equilibrium model. In addition, the assessment of the equilibrium level using the Hodrick-Prescott filter is not very accurate for end-point data.
The foreign economy is different from the rest of the world. The latter also includes other countries producing the primary commodity.
It is assumed that labor can freely move across sectors within each region (domestic and foreign) but cannot move across regions.