Oliver Holtemöller, Ph.D., Department of Business and Economics, RWTH Aachen University, Templergraben 64, Aachen, 52062, Germany and Sushanta Mallick, Ph.D., School of Business and Management, Queen Mary University of London, Mile End Road, London, London E14NS, United Kingdom.
This study is aimed at evaluating the degree of misalignment between the real exchange rate and a set of fundamental macroeconomic variables. The equilibrium exchange rate is assessed with reference to natural emplyoment, which is consistent with recent studies based on the Fundamental Equilibrium Exchange Rate (FEER) normative approach. The degree of misalignment in the real exchange rate is examined for several emerging market economies using a model in which current account balance is consistent with the prevalent conditions in domestic markets. Cointegration tests are employed in order to establish whether there exists a long-run relationship between the real exchange rate and the underlying macroeconomic variables. Subsequently, the degree of misalignment in the real exchange rate path from its long-run equilibrium value is ascertained. The specific long-run equlibrium real exchange rate along with the misalignment between the actual and the equilibrium rate are estimated with a vector autor-regressive model using a vector error correction mechanism. The calculation of the equlibrium level of the exchange rate is based on implied consistency between internal and external balances, along with the parameters estimated by using the fundamental determinants of the actual real exchange rate.