The Real Exchange Rate Misalignment in the Five Central European Countries — Single Equation Approach

Abstract

Both policy makers and market participants have a strong interest in appropriate estimates of equilibrium real exchange rates and their prospective movements. They have also a keen interest in understanding determinants of the equilibrium real exchange rate and the factors behind implied misalignments of the actual rate from its equilibrium level. The real exchange rate is viewed as a key indicator of external competitiveness. Hence, a real appreciation of the exchange rate is often interpreted as a loss of price competitiveness. Nevertheless, this applies only if the real exchange rate becomes overvalued in relation to the equilibrium one. At the same time, real exchange rate appreciation can simply reflect improved competitiveness thanks to an increase in productivity. In this sense, the study of the determinants of the real exchange rates may shed some light on whether a real appreciation causes a loss in competitiveness or reflects the improvements in it (see also Frait and Komârek (1999, 2001)). The real exchange rate misalignments may be rather costly. Both overvalued and undervalued currencies have their negative implications. From policymakers’ perspective, the risks implied by the overvaluation are more important. There is an empirical support for the view that an overvalued currency leads to lower economic growth, especially via the impact on the manufacturing (see e.g. Razin and Collins, 1997).