Commercial Policy, Terms of Trade and the Equilibrium Real Exchange Rate

Abstract

In modern theories of real exchange rate behavior movements in the equilibrium value of the real exchange rate will respond to changes in its determinants, including the terms of trade, underlying sustainable capital flows, and long term desired levels of protection (see Edwards, forthcoming). An important implication of this modern approach is that equilibrium movements in the real exchange rate do not require policy interventions. On the contrary, under these circumstances, policy actions aimed at precluding real movements will interfere with equilibrium changes, rendering the adjustment process more difficult. From a policy perspective a crucial aspect of real exchange rate analysis is to understand how the equilibrium real rate changes when the economy is subject to policy-induced or external disturbances. Once the behavior of the equilibrium real exchange rate is understood, it is possible to determine whether the real exchange rate, in a particular moment in time, is overvalued or undervalued. In this paper the effects of reforms of commercial policies (i.e., trade liberalization reforms) and terms of trade changes on the behavior of the equilibrium real exchange rate are analyzed in detail.1 The paper deals with some important theoretical aspects, and reviews the empirical literature on the subject. The paper is organized in the following form: In Section I the traditional theoretical aspects of the relationship between long run commercial policies and the equilibrium real exchange rate are reviewed. The discussion focuses first on the long-run case, where it is assumed that all factors of production can move freely across sectors next the short-run effects are analyzed ; here it is assumed that only one factor(labor) can move freely across sectors. The transition period is