Estimating Equilibrium Real Exchange Rate

1. Estimating Equilibrium Real Exchange Rate MSc.Student: Petcu C@t@lin Supervisor: Mois@ Alt@r

2. Topics • Introduction • Overview of Literature • Theoretical Framework and Models • Empirical Analysis • Conclusion

3. Introduction • Important for future economic development • Exchange rate misalignment - direct effects on the economy - EU admission • VECM - Cointegration

4. Overview of literature PPP equilibrium • Cassel (1922) • Chinn (1999) • Sarno and Taylor(2002) “Reduced Form” approach (single equation) • MacDonald(1997) • Clark & MacDonald(1998) • Elbadawi(1999) • Halpern & Wyplosz(1997) Macroeconomic Equilibrium approach • normative models: FEER, DEER • positive models: NATREX, BEER, PEER Studies on EU accession countries • Alberola et al.(1999) • Egert (2002), • Elbadawi(1999) • Halpern & Wyplosz(2001) • Filipozzi(2000) • Kemme & Tang (2002) • Barlow & Radulescu (2002) • Jörg Rahn(2003)

5. Theoretical framework and models RER measure Combines nominal exchange rate (S) with measures of domestic(P) and overseas prices(P*). Multilateral real exchange rate (REER):

6. BEER - PEER approach • Theoretical background: - a country with a small open economy with two sectors of goods (tradable and non-tradable) - two fundamentals : - foreign asset position - sectoral productivities - relative prices Real exchange rate components: qt =[((st + ptT*) – ptT ] + [α(ptN – ptT) – α*(ptN* - ptT*)] qtX qtI α, γ<0

7. The real exchange rate becomes: The econometric methodology: - Cointegration - Vector error correction Estimation of equilibrium values of the variables: Time series approach: (BEER) - the transitory part of each series is eliminated by applying an econometric filter to smooth the series -the obtained series are used in the model Hodrick- Prescott filter: - computes the smoothed series “s” by minimizing the variance of initial series around the computed one, subject to a penalty that constrains the second difference of it. - in the estimation I use an smoothing parameter value of 50, because is very similar to the 2 year moving average

8. Orthogonal decomposition: (PEER) (Gonzalo - Granger (1995)) - the transitory component does not Granger cause the permanent component - the permanent component is a linear combination of observed variables where xt is the vector of fundamentals=[REERt,NFAt,PNTt]’ and will be decompose into permanent: xtP=[REERtperm, NFAtperm, PNTtperm]’ and transitory xtT=[REERttrans, NFAttrans, PNTttrans]’ components. where α┴,β┴ are the orthogonal components, defined as the eigenvectors associated with the unit eigenvalues of the matrices: ( ) and ( ) .

9. Three equation system cointegration - more complete model - based on Montiel(1999) model extended by Egert (2002) - internal and external balances are estimated trough their own determinants – internal balance: PNT+ β1SALACT (β1<0) – external balance: NFA+ β1CA (β1<0) – equilibrium real exchange rate: REER+ β1PNT+ β2NFA(β1,β2>0)

10. The monetary approach Exchange rate is considerate the relative price of two monies: the domestic money and the foreign money Changes in relative magnitudes of foreign and domestic monetary aggregates ,inflation differentials, or interest rate differentials The methodology is based on VECM model: Equilibrium values of determinants are estimated with Hodrick - Prescott filter

11. Empirical analysis • Results • Data set

12. Data set lnREER - the real effective exchange rate It is defined as the log of a CPI-deflated index based on German mark and US dollar bilateral exchange rates. The weights used for computing the effective real exchange rate correspond to the structure of foreign trade in terms of openness to the EU-15 (for the German mark), 60%, and to the rest of the world (for the US dollar), 40%. ln PNT - the relative price (productivity level differential) Defined as the ratio of the domestic consumer price index to the domestic producer price index relative to the corresponding foreign ratio, using the same trade weights as for the real effective exchange rate. NFA_PIB - the net foreign asset stock It is defined as the stock of net foreign assets from the banking system. In order to adjust for the size of the country, net foreign assets were normalized by nominal GDP. Back

13. SALACT - Real salaries - are obtained from nominal salaries deflated with CPI CONTCURENT_PIB - Current account balance - normalized to GDP LNCR - Currency reserves - the log of the stock hold by National Bank CAPITALFLOW - Foreign capital flow - the log of the foreign capital in the banking system RDID - The real interest rates differential - determined as a difference between the real interest rate on the Romanian market and an international real interest rate for Germany and US using the same weights as before. Back

14. Results Unit root tests:

15. BEER Approach Test for lag length criteria:

16. Test for cointegration: Cointegration relationship (t-statistic in brackets): (3.4398) (6.58846)

17. Error correction: Estimated behavioral equilibrium exchange rate

18. Orthogonal components LNREERW PNTT NFAT α┴ -0.8266854 0.5624809 0.0143719 β┴ 0.5964793 -0.5605464 0.5744564 PEER Approach Orthogonal components:

19. Estimated permanent equilibrium exchange rate

20. System cointegration Restriction on the coefficient matrix Cointegration test:

21. System cointegration vectors: – internal balance: PNT +β1SALACT [1;-0.473] – external balance: NFA+ β1CA [1;-0.203] – equilibrium real exchange rate: REER+ β1PNT+ β2NFA [1;1.83;0.02]

22. Monetary approach Test for lag length criteria:

23. Test for cointegration: Cointegration relationship (t-statistic in brackets): (6.93) (3.50) (4.51)

24. Error correction: Estimated behavioral equilibrium exchange rate in monetary approach

25. Conclusion The equilibrium real exchange rate is the level to which the RER will tend in the long run. If at EMU entry Romanian currency will be undervalued or overvalued against euro the adjusting to equilibrium will involve significant costs. Even in the case of an exchange rate very much consistent with internal and external balance it will still exist the danger of real appreciation over the future fixed parity