Exchange rate management in transition economies

This paper proposes to combine the traditional approach to real exchange rate determination with the new policy reaction function that explains nominal exchange rates. We develop a dynamic optimizing model of real exchange rate determination in an advanced transition economy. The model focuses on real factors that determine the evolution of saving, investment, productivity, and economic growth, that in turn alter the country’s external balance and the equilibrium real exchange rate. We use an inter-temporal model of consumer and producer optimization to explain how the elimination of inherited structural distortions, particularly investment subsidies, may affect equilibrium real exchange rates, and then examine the empirical evidence from Poland, the Czech Republic, and Hungary to evaluate predictions of our theoretical model.

The data we use are quarterly time series (1996-2016) of the real consumer price index based on real exchange rate indices (2005=100) and the suggested explanatory variables, collected from Eurostat. Government debt and investment are taken as a percentage of gross domestic product (GDP). The productivity differential is expressed as GDP per employment. Openness is given by exports plus imports relative to GDP. Dummy variables capture the effects of the financial crisis and shifts in currency regimes. After performing an augmented Dickey-Fuller test, individual ordinary least squares regressions are performed on the log of the real exchange rate to identify possible effects of fundamentals (such as government debt, investment, productivity, and openness) and macroeconomic policies on equilibrium real exchange rates.

Our goal is to see to what extent we can explain the reversal of real exchange rate trajectories, from appreciation before the 2008 recession to depreciation in its aftermath, by the change in the fundamental factors. In addition, we propose an exchange rate policy reaction function that links the nominal exchange rate with the gap between the desired and actual fulfilment of criteria for a country’s internal and external balance. The purpose of this reaction function is to capture the likelihood that transition economies will endorse a shift in currency regimes, moving from real exchange rate adjustment within a currency union to more flexible rates. This may, in turn, explain how long the examined countries may hesitate before adopting the euro as their national currency.

The initial results of our model suggest that, if the Eastern European economies attempt to restore the balance between consumption and investment in the nontradables sector, their real exchange rate may have to depreciate over time.