Estimating the Half-Life of Theoretically Founded Real Exchange Rate Misalignments
This paper models empirically the short and long-term behavior of the real exchange rate misalignment -- a key variable in academic and policy circles. The equilibrium real exchange rate is derived from a theoretical model with intertemporal extern...
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| Language: | English en_US |
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World Bank, Washington, D.C.
2013
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| Online Access: | http://documents.worldbank.org/curated/en/2013/04/17582694/estimating-half-life-theoretically-founded-real-exchange-rate-misalignments http://hdl.handle.net/10986/14450 |
| Summary: | This paper models empirically the short
and long-term behavior of the real exchange rate
misalignment -- a key variable in academic and policy
circles. The equilibrium real exchange rate is derived from
a theoretical model with intertemporal external equilibrium
and internal equilibrium (in traded and non-traded markets)
based on the current account dynamics and
Harrod-Balassa-Samuelson productivity, respectively. This
provides a bridge between theory and empirics that links the
real exchange rate and its fundamentals (terms of trade, the
ratio of net foreign assets to gross domestic product, and
productivity differentials). The paper contributes to the
literature by: (a) estimating an unrestricted vector error
correction model that examines the short-term dynamics of
real exchange rate misalignments and links these deviations
with shocks to fundamentals from 1970 to 2010, and (b)
computing the speed of reversion of real exchange rate
misalignments with respect to a fundamentals-based
equilibrium level. The paper reconciles two strands of the
empirical literature that estimate the half-life of
purchasing power parity deviations: one, the linear
adjustment model that renders the consensus half-life
estimates of purchasing power parity deviations, and
another, the non-linear adjustment model of purchasing power
parity deviations. The model estimates the half-life of real
exchange rate deviations from their fundamental equilibrium
at approximately 2.8 years. Consequently, about 25 percent
of the real exchange rate deviation from its equilibrium
level is corrected in the next year. Approximately 43
percent of the countries in the sample have a half-life of
real exchange rate deviations from equilibrium less than 2.5
years -- which is consistent with predictions from
non-linear mean reversion models. |
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