FUNDAMENTAL LITERATURE ON REAL EXCHANGE RATE

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CHAPTER 2. FUNDAMENTAL LITERATURE ON REAL EXCHANGE RATE

Introduction

This chapter discusses the fundamental literature on the real exchange rate. It starts with the conceptual definition of the real exchange rate, the analytical framework and theoretical model. The chapter also reviews the literature on the fundamental factors that influence the real exchange rate as well as the empirical studies on the real exchange rate. The chapter is organised as follows. Section 2.2 discusses briefly the theoretical foundations of real exchange rate. Section 2.3 provided concepts and definitions. Section 2.4 deals with analytical framework. Section 2.5 presents the theoretical model. Section 2.6 reviews the literature on fundamentals and empirical studies. The conclusion is provided in Section 2.7.

Theoretical Foundations of Real Exchange Rate

Frequent movements in the real exchange rate had been and still are regarded as temporary divergence of the real exchange rate from its sustainable equilibrium value.The purchasing power parity (PPP) hypothesis remains a prevailing pattern in the discussion of the real exchange rate and other topics of international finance. The PPP hypothesis was pioneered by Cassel (1922) and states that the nominal exchange rate should reflect the purchasing power of one currency against another. According to Cassel (1922: 140-162) the purchasing power exchange rate is measured by the reciprocal of one country’s price level, 1/P against another, 1/P*, where 1/P and 1/P* are domestic and foreign countries’ internal purchasing power parity. The purchasing power parity rate is a rate at which the nominal exchange rate e would tend. This is when trade imbalances,speculation, central bank intervention and other barriers to trade do not exist. It is expressed as: e =(1/P*)/(1/P)=P/P*=n, where n is purchasing power exchange rate. The real exchange rate, rer is defined as ⋅ PPe ./*)( If absolute PPP holds rer =1. The relative version of the PPP which uses price indexes allows rer to be some constant scalar Ф (see Breuer, 1994: 247). The PPP hypothesis is tested empirically as t ttt ln e βα pp )ln( +−+= ε*,where tp and *tp are domestic and foreign prices and tε is the error term. If there is absolute PPP α = 0 and β = 1 . Evidence of relative PPP requires that α will not be zero.The PPP equation has been tested empirically, and Officer (1976), Isard (1976) and Frenkel (1978; 1981), were some of the first notable studies. Isard (1976) and Officer (1976) did not find evidence in support of the PPP hypothesis. However, Frenkel (1978,1981) found evidence in favour of the PPP hypothesis. Breuer (1994: 263-274) summarised some empirical studies on the PPP hypothesis and showed that many studies did not find evidence in support of the PPP hypothesis. There were few studies that supported the PPP hypothesis before the late 1980s, but after that period most studies rejected the PPP hypothesis. Although the PPP had served as and still regarded as a benchmark for the value of currencies it is not an appropriate representation of the equilibrium real exchange rate especially when fundamental disturbances exist (Allen, 1995: 1). It only relates the exchange rate to the relative foreign and domestic prices. Allen argues that the natural real exchange rate offers an alternative pattern or paradigm for the equilibrium real exchange rate. The natural real exchange rate refers to medium term and inter-cyclical equilibrium real exchange rate. It is the equilibrium real exchange rate that clears the balance of payments when cyclical factors, speculative capital flows and movements in international reserves do not exist (Allen, 1995: 6). This equilibrium real exchange rate changes when there is a movement in the fundamentals.The natural equilibrium real exchange rate approach identifies the fundamental determinants and models for estimation (of the equilibrium real exchange rate). This approach is mainly empirical and it aims at explaining long-term movement of the real exchange rate. Fundamental disturbances (which will be explained later in this study) occur regularly and move the natural equilibrium real exchange rate to a new long-run value, and does not (the natural equilibrium real exchange rate) reach a steady state.According to Allen (1995: 9) since the fundamental disturbances are not constant around the mean, the real exchange rate will also not be moving around the mean. If that was the case, then the real exchange rate will also converge to a given mean or trend. The main criticism of the PPP hypothesis is that it does not take into account of movements in the fundamentals. It postulates that the real exchange rate is stationary around a given mean and fluctuations in the nominal exchange rate are solely attributed changes in relative prices. The natural real exchange rate is also supported by Stein (1994: 137) who argues that the PPP hypothesis is not correct and must be replaced by the natural real exchange rate generated by the fundamentals. Stein provided empirical evidence using USA data that the real exchange rate has not been stationary.
Williamson (1983, 1994) also rejected the PPP postulation that the equilibrium real exchange rate is an immutable number. He argued that the real exchange rate changes over time and this can be caused by factors such as productivity. If a country is growing faster than others the real exchange rate will appreciate. Other fundamentals such as accumulation of foreign liabilities by a country in order to finance its deficit, and changes in the terms of trade also cause the real exchange rate to fluctuate. Williamson proposed a fundamental equilibrium real exchange rate. The fundamental equilibrium real exchange rate is a rate which is in line with macroeconomic balance. This means that internal and external balances are achieved.The fundamental equilibrium real exchange rate differs from the natural equilibrium real exchange rate in the sense that it is a rate that will guide policy. It is a measure that makes the current account to be consistent with sustainable capital flows. According to Allen (1995: 10) and Williamson (1994: 180) the fundamental equilibrium real exchange rate is normative and this is the main difference with the natural equilibrium real exchange rate. The natural equilibrium real exchange rate takes the fundamentals such as trade and commercial policies as given, and has no judgement as to whether the fundamentals are in line with the welfare of the country. This analysis illustrate that there is a criticism of the PPP hypothesis and the natural real exchange rate which is a function of fundamentals has gained popularity in real exchange rate discussions.

Concepts and definitions

There is no single definition of the real exchange rate that is accepted generally by economists as well as analysts. Montiel (2003: 312) defines in broad terms the real exchange rate as the relative price of foreign goods in terms of domestic goods. Montiel notes that what constitutes domestic and foreign goods depends on the particular analytical framework and the specific macroeconomic model being used. Economists use different types of models for different purposes and this cause a variety of analytical real exchange rate definitions.Hinkle and Nsengiyuma (1999: 41) define the real exchange rate in two ways. The first is in external terms where real exchange rate is defined as the nominal exchange rate adjusted for differences in price level between economies and these are measured in a common currency. The second way defines real exchange rate in internal terms as the ratio of local price of tradable to nontradables within a country. The first way of defining real exchange rate derives originally from the purchasing power parity (PPP) theory and it compares the relative value of currencies by measuring the relative prices of foreign and domestic consumption baskets. The second way of real exchange rate definition captures the internal relative price incentive in a particular economy for the production or consumption of tradable as opposed to nontradables goods. In this latter definition, the real exchange rate is an indicator of resource allocation and incentives in the local economy. Edwards (1988a) also defines the real exchange rate as the ratio of the prices of tradables to nontradables (RER= price of tradable goods/price of nontradable goods), where RER is real exchange rate. In practical terms it is not easy or straightforward to calculate the ratio of prices of tradables to nontradables, and a more operational definition of the real exchange rate is computed as: RER =EPT/PN, where E is the nominal exchange rate defined as units of domestic currency per unit of foreign currency, PT is the world price of tradable goods, PN is the domestic price of nontradable goods. Empirically, PT and PN are proxied by foreign price level such as wholesale price index and the local consumer price index. Using this definition, an increase in RER is described as appreciation and a decrease is described as depreciation.
Equilibrium real exchange rate is defined as the value of the real exchange rate where internal and external equilibrium are attained at the same time. The economy is in internal equilibrium when there is a clearing in the nontradable goods market. External equilibrium is attained when the current account is sustainable. This is a situation in which the country’s current account deficit is equal to the value of sustainable capital inflows that it can expect to receive (Edwards, 1988a: 4; Montiel, 2003: 316).The definition of the equilibrium real exchange rate raises an important question on what it takes for macroeconomic equilibrium to be sustainable. Montiel (2003) suggests that this question can be answered by formalising the dynamic structure of the economy. The exchange is determined at any moment in time by predetermined variables, exogenous policy variables and other exogenous variables (see also Edwards, 1988a). Predetermined variables are endogenous that change slowly over time, for example the capital stock of the economy, technology and the country’s international net creditor position. Exogenous policy variables are variables which are under the control of the domestic authorities. These include fiscal, monetary and trade policies. Other exogenous variables are variables that can be regarded as random shocks and bubble variables because they affect the economy through their influence on expectation. These include variables such as weather, terms of trade and world interest rates. The economy determines the values of endogenous variables such as the real exchange rate and the rate of change of predetermined variables. Montiel (2003) and Edwards (1988a) noted that the actual real exchange rate observed at any time may be influenced 23 by speculative bubble factors, by actual values of predetermined variables and transitory variables of policy and exogenous variables. If the variables on which the actual real exchange rate depends become unsustainable the actual real exchange rate will tend to change over time. Speculative factors are generally short-lived and transitory and in this case, short-run equilibrium real exchange rate can be derived. The equilibrium real exchange rate in the short run is conditioned on the short-run fundamentals. Montiel (2003: 317) states that the short-run equilibrium real exchange rate will not be sustainable because the policy and exogenous variables that affect it can deviate from their sustainable values. The short-run equilibrium real exchange rate can be expected to change when policy and exogenous variables change. In addition to that, even if the policy and exogenous variables are at their sustainable levels, predetermined variables may not have completed their adjustment to permanent positions. Changes in predetermined variables would result in the short-run real exchange rate to change even if there are no adjustments in the policy and predetermined variables. According to Montiel predetermined variables will stop changing when they reach a steady state. Hence, the long-run equilibrium real exchange rate depends only on the sustainable values of the exogenous and policy variables which affect the real exchange rate directly. Edwards (1998a; 1998b; 1989) calls these variables long-run fundamentals. Despite the fact that the equilibrium real exchange rate depends on permanent variables,the actual real exchange rate responds to both short and permanent variables. The existence of equilibrium does not mean that the actual real exchange rate is always similar to the equilibrium real exchange rate. The actual real exchange rate often moves away from its equilibrium in the short-run. According to Edwards (1988a: 9) short-run and medium-run deviations which are not very large and result from temporary changes in real variables can be quite common. Other types of deviations can generate a large and persistent difference between the actual and equilibrium real exchange rates. The gap between actual and equilibrium real exchange rates is called real exchange rate misalignment. Real exchange rate misalignment is a continuous movement away of the exchange rate from its long-run equilibrium level (see also Williamson, 1983: 13).

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ACKNOWLEDGEMENTS
SUMMARY
LIST OF ACRONYMS
CHAPTER 1. INTRODUCTION 
1.1 Introduction
1.2 Introduction to Real Exchange Rate Theory
1.3 Overview of the Exchange Rate Policy in Namibia
1.3.1 Monetary and Exchange Rate Arrangements
1.3.2 The CMA and Optimum Currency Areas
1.3.3 Implications for Monetary and Exchange Rate Policies
1.4 Statement of the Research Problem 
1. 5 Objective of the Study 
1.6 Methodology
1.7 Outline of the Study
CHAPTER 2. FUNDAMENTAL LITERATURE ON REAL EXCHANGE RATE
2.1 Introduction
2.2 Theoretical Foundations of Real Exchange Rate
2.3 Concepts and definitions
2.4 Analytical Framework
2.4.1 One-Good Model
2.4.2 Complete Specialisation Model
2.4.3 Dependent Economy Model
2.4.4 The Three-Good Model
2.5 Theoretical Model
2.6 Real Exchange Rate Fundamentals and Empirical Studies 
2.6.1 Real Exchange Rate Fundamentals
2.6.2 Empirical Studies
2.7 Conclusion 
CHAPTER 3. REAL EXCHANGE RATE AND COMMODITY EXPORTS’ PRICES 
3.1 Introduction
3.2 Literature and Empirical Studies 
3.3 Empirical Model for Namibia
3.4 Conclusion
CHAPTER 4. REAL EXCHANGE RATE MISALIGNMENT
4.1 Introduction
4.2 Theory and Literature 
4.3 Impact of Real Exchange Misalignment on Economic Performance 
4.4 Correction of Real Exchange Rate Misalignments
4.5 Conclusion 
CHAPTER 5. ECONOMETRIC ANALYSIS OF REAL EXCHANGE RATE IN NAMIBIA 
5.1 Introduction
5.2 Estimation Technique 
5.3 Data
5.4 The Three-good model
5.4.1 South Africa’s Exchange Rate Policy and its Implication for Namibia’s Real Exchange Rate
5.4.2 Developments in Namibia’s Key Fundamental Determinants of the Real Exchange Rate
5.4.3 Univariate Characteristics of the Variables and VAR Order
5.4.4 Testing for Reduced Rank
5.4.5 Long-run Restrictions
5.4.6 Exogeneity Test and Speed of Adjustment
5.4.7 Impulse Responses
5.4.8 Variance Decomposition.
5.4.9 Equilibrium Real Exchange Rate
5.5 Real Exchange Rate and Commodity Prices
5.5.1 Developments in Commodity prices and Productivity
5.5.2 Univariate Characteristics of the Variables and VAR Diagnostic Statistics
5.5.3 Testing for Reduced Rank
5.5.4 Long-run Restrictions
5.5.5 Exogeneity Test and Speed of Adjustment
5.5.6 Impulse Responses and Variance Decomposition
5.5.7 Robustness of the VECM Results
5.5.8 Equilibrium Real Exchange Rate
5.6 Conclusion
CHAPTER 6. EMPIRICAL RESULTS OF REAL EXCHANGE RATE MISALIGNMENT AND ECONOMIC PERFORMANCE 
6.1 Introduction
6.2 Impact of Real Exchange Rate Misalignment on Namibia’s Economic Performance and Competitiveness 
6.3 Real Exchange Misalignment Computed from the Three-Good Model (Fundamental Approach) 
6.3.1 Testing for Reduced Rank
6.3.2 Impulse response functions
6.3.3 Variance decomposition Analysis
6.4 Misalignment computed from the Cashin et al. Model (real exchange rate and commodity prices) 
6.4.1 Univariate Characteristics of Data and Test for Reduced Rank
6.4.2 Impulse Response
6.4.3 Variance Decomposition Analysis
6.5 Conclusion 
7. CONCLUSION
7.1 Introduction
7.2 Methodology
7.3 Literature
7.4 Empirical Results
7.5 Overall Conclusion and Policy Implications 
8. REFERENCES 
9. APPENDIX

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