A Medium-Term Framework for Analyzing the Real Exchange Rate, with Applications to the Philippines and Tanzania

Abstract

A competitive official real exchange rate is important to external balance and sustainable medium-term growth in developing countries. This article presents a methodology for estimating the appropriate real rate and provides a basis for evaluating the extent to which the prevailing rate is misaligned. In particular, the medium-term equilibrium real exchange rate is evaluated by estimating the effects of structural factors on the trend observed for a country's real rate compared with the rates of its major trading partners, taking into account the effects of macroeconomic policy. Structural factors include terms of trade, external capital flows, and trade policy, plus other factors relevant to the circumstances of individual countries. The implied change in the medium-term equilibrium real rate is compared with that of a historical reference period. The application of this methodology to two developing countries, the Philippines and Tanzania, illustrates how it can complement and improve upon other analytic approaches, such as those using purchasing power parity and analysis of parallel rates. This approach is complemented by an analysis of the relation between a country's real exchange rate and those of its major competitors.