Estimating Equilibrium Real Exchange Rate MSc.Student: Petcu Supervisor:

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

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

Overview of literature PPP equilibrium Cassel (1922) Chinn (1999) Sarno and Taylor(2002) Macroeconomic Equilibrium approach normative models: FEER, DEER positive models: NATREX, BEER, PEER “Reduced Form” approach (single equation) MacDonald(1997) Clark & MacDonald(1998) Elbadawi(1999) Halpern & Wyplosz(1997) 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)

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):

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: q t =[((s t + p t T *) – p t T ] + [α(p t N – p t T ) – α*(p t N * - p t T *)] qtXqtX qtIqtI α, γ<0

The real exchange rate becomes: The econometric methodology: - Cointegration - Vector error correction 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 Estimation of equilibrium values of the variables:

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 x t is the vector of fundamentals=[REER t,NFA t,P NT t ]’ and will be decompose into permanent: x t P =[REER t perm, NFA t perm, P NT t perm ] ’ and transitory x t T =[REER t trans, NFA t trans, P NT t trans ] ’ components. where α ┴, β ┴ are the orthogonal components, defined as the eigenvectors associated with the unit eigenvalues of the matrices: ( ) and ( ).

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: P NT + β 1 SALACT ( β 1 <0) – external balance: NFA+ β 1 CA ( β 1 <0) – equilibrium real exchange rate: REER+ β 1 P NT + β 2 NFA( β 1, β 2 >0)

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

Empirical analysis Results 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 %. 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. ln P NT - 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. Back

SALACT - Real salaries - are obtained from nominal salaries deflated with CPI CONTCURENT_PIB - Current account balance - normalized to GDP CAPITALFLOW - Foreign capital flow - the log of the foreign capital in the banking system LNCR - Currency reserves - the log of the stock hold by National Bank 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

Results Unit root tests:

BEER Approach Test for lag length criteria:

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

Estimated behavioral equilibrium exchange rate Error correction:

PEER Approach Orthogonal components: Orthogonal components LNREERWP NT TNFAT α┴α┴ β┴β┴

Estimated permanent equilibrium exchange rate

Restriction on the coefficient matrix Cointegration test: System cointegration

– internal balance: P NT +β 1 SALACT [ 1; ] – external balance: NFA+ β 1 CA [ 1; ] – equilibrium real exchange rate: REER+ β 1 P NT + β 2 NFA [ 1;1.83;0.02 ] System cointegration vectors:

Monetary approach Test for lag length criteria:

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

Estimated behavioral equilibrium exchange rate in monetary approach Error correction:

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