Real exchange rate assessment in the GCC countries — a trade elasticities approach

Abstract

This article adopts new panel econometric methods to assess real exchange rate alignment with economic fundamentals in the countries of the Gulf Cooperation Council (GCC), using a theoretical approach popularized by Paul Krugman in the late 1980s. Results from panel econometric applications of the Krugman model yield low levels of real exchange rate undervaluation in the GCC countries, although indicating persistence of undervaluation – albeit statistically low – into the medium term. They also show that the recent real exchange rate undervaluation could be characterized as due to ‘short-run frictions and adjustment costs’ associated with continued depreciation of the US dollar to which GCC countries’ currencies are pegged. Further, failure to find supporting evidence for the Marshall–Lerner condition underscores the propriety of using fiscal policy rather than exchange rate policy to address recent inflationary pressures and help resolve lingering global financial imbalances.