Theory and Empirics of Real Exchange Rates in Developing Countries

Raimundo Soto and Ibrahim Elbadawi

No 324, Documentos de Trabajo from Instituto de Economia. Pontificia Universidad Católica de Chile.

Abstract: This paper develops a general equilibrium model of the real exchange rate for a small open economy, taking into account often overlooked characteristics of developing economies, such as the presence of significant aid flows, terms of trade variability, distorting trade taxes, and concentration of exports on natural resources. The equilibrium RER results from the intertemporal, optimal decisions of households on consumption, production, and trade of different goods, conditional upon government policies and external conditions. The model derives a concept of the sustainable current account based on the yield of the discounted present value of net exports which provides a rigorous framework for the computation of the equilibrium RER and misalignment indexes. We test the model in a sample of 73 developing countries in the 1970-2004 period using the PMG estimator proposed by Pesaran et al. (1999) and find it to be an encompassing representation of the data. We also develop a methodology to compute the misalignment of the real exchange rate, which requires to compute the permanent components of the determinants of the RER and to identify the equilibrium path for each country.

Keywords: Real exchange rates; general equilibrium; misalignment; panel data (search for similar items in EconPapers)
JEL-codes: C23 F31 F37 (search for similar items in EconPapers)
Date: 2007
New Economics Papers: this item is included in nep-cba, nep-dev, nep-ifn and nep-lam
References: Add references at CitEc
Citations: View citations in EconPapers (8)

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Persistent link: https://EconPapers.repec.org/RePEc:ioe:doctra:324

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