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The Long-Run Determinants of the Real Exchange Rate in Transition Economies MSc: CĂLĂVIE ALINA MIHAELA Supervizor: ALTĂR MOISĂ CONTENT Literature Review Theoretical Background Determinants of the Real Exchange Rate in Transition Economies: A Model Empirical Analysis for Romania Conclusion 1. LITERATURE REVIEW Fundamental Behavioural Models Models Williamson (1983) - FEER Clarck & MacDonald (1998) - BEER Williamson (1994) Stain & Allen (1995) - NATREX Feyzioglu (1997) Elbadawi (1995) Halpern & Wyplosz (1997, 2002) Frait & Komarek (2001) 2. THEORETICAL BACKGROUND Real Exchange Rate and External Competitiveness Real appreciation can be interpreted as a loss of competitiveness only if the RER becomes overvalued in relation to its equilibrium value. The competitiveness must be interpreted with respect to the main trading partners, different world regions and different group of producers. Real Exchange Rate, Double-Speed Economy and Deindustrialization Due to the weak institutional framework, the inefficient domestic firms are not forced to leave the market and they burden the cost of the efficient ones. Keeping the trained employees in the old sector may artificially delay the restructuring process. Deindustrialization and real appreciation are simultaneously determined by the productivity gains in industrial production. Real Exchange Rate as an Indicator of Convergence Real exchange rate development can be seen as a common denominator since the external purchasing parity of transitional countries’ currencies is determined primarily by their relative productivities. The real appreciation also implies the convergence of price levels of these countries to the EU countries. R Appreciation (ERDI) ERER (successful transformation) ERER (unsuccessful transformation) ERDI>1 Initial real undervaluation R=ERDI=1 PPP ERDI<1 Time What is the equilibrium real exchange rate? PPP – Purchasing Power Parity It assumes that the real exchange rate equilibrium remains stable over a long period. It does not take into account for structural changes. ERER – Equilibrium Real Exchange Rate: the rate consistent with the country’s macroeconomic balance, including both internal and external balances. Any change in fundamental determinants of internal or external balance can affect the value of the ERER. DETERMINATS OF THE RER IN A SMALL OPEN TRANSITIONAL ECONOMY Definition of the RER The real exchange rate can be defined as the nominal exchange rate (E ), times the ratio of foreign to domestic prices (P*/P). RER EP * / P where the domestic price index is: (1 a b ) P P P Pn a b m x and the foreign price index is: P* Pna* Pxb* Pm1a* b*) * * ( * THE MODEL Hypotheses - the currency convertibility is already established - there are no quantitative restrictions on foreign trade - managed float exchange rate regime - the prices of tradables and nontradables are liberalized - strong monopolistic structure - subsidization of the nontradables sector - price rigidity and inflexible wages Consumer’s optimization problem: i i i max U i Cn , Cm , M d pn C n pm C m M d V M 0 i i i i Profit maximization in the nontradables sector: pn (1 j )[ wLn / Qn sn ] pn pn ( j, w, sn , C ) Profit maximization in the tradables sectors: pi pi ( pi* , E ) Li Li ( w, pi , si ) i m, x Qi Qi ( w, pi , si ) Given managed exchange rates: CA KA F1 F0 Total product, in nominal terms, equals: Y ( pn sn ) Qn pm Qm ( p x s x ) Qx The budget deficit can be written, in nominal terms, as: D pn Gn (1 / E ) pm Gm sn Qn s x Qx (1 / E ) x p * Q x (1 / E ) f pm I m * x * The overall change in the money supply is given by: M s1 M s 0 D ( F1 F0 ) The nominal exchange rate is market determined, so: E E[ F , D(G, s, taxes ), w, i] Consequently, the real exchange rate can be written as: RER RER [ pn ( j , w, sn , C n ), pm ( pm , E ), p x ( p * , E ), D(G, s, taxes ), F , w, i ] * x A Basic Introduction to the Romanian Economic Context Price liberalization The initial process was built up in three rounds: in November 1990, in April 1991 and in July 1991 During 1994-1996 controls were reintroduced, especially on food prices. In early 1997 most prices were liberalized. The weight of administrated prices in the CPI basket reduced at about 15 percent. Soft budget constraints and the arrears Soft budget constraints and weak corporate governance allowed a faster wage growth, especially in 1995, 1996 and 1998. This problem is acute in the case of major utilities. Despite the losses and arrears, the wages in this sector remain some of the highest in Romania. Exchange rate regime liberalization 1992: the actual exchange rate regime was introduced. Its main features are full retention regime and the convertibility of the Leu Until the end of 1996 administrated controls persisted, which led to the existence of three exchange rates in parallel. January 1997: a managed float rate was introduced. Mid-1999: Romania faced some difficulties with reimbursement of the foreign debt. The NBR had to interfere in order to stop the excessive depreciation of the Leu. Foreign trade liberalization The policies adopted aimed the geographical diversification and restructuring of exported and imported commodities. Trade liberalization is relatively high in Romania. Empirical Analysis of the Real Exchange Rate Determinants: The Case of Romania ln rer f (ln tnt, ln w, nfa, open) - - - + lnrer – –the real wageexchange rate open––netThe realprice of non-traded to traded goods nfa openness relative lntnt theforeign assets lnw The tradables pricesare rate between the nominal assets exports Net foreign assets definedapproximated by foreignthe prices, The openness is the ratio the defined imports wage minus calculated as were as as sum of as The isreal exchange defined is the total the non-food nominal It and in the exchange nontradables consumer price GDP.the as the weighted while the to and the prices were with national economy ROL/USD deflatedcomputed GDP. (expressed inrate foreigners, expressed on a ratio to consumer price total liabilitiesnational currency) scaled as index. average of food and in the index means prices. index. foreign assets toservices nominal wageof a real establishedthe The decrease measure the effects is often appreciation Openness is economies theas a measure of trade regime on by used appear Net In transition country’s external of ratio An with intoof and the direct toin worker’s nominal Thisthe Leu taken respect to mayorder toquotation. measure of collective bargaining. Exogenous increases the as the Balassa- increase account in be interpreted equilibriumisexchange ratenfa certainly leads measureappreciation of position. a wage determine inflation pressuresthat transition net the degree of effect. This means in the of More open regimes are national foreign the liberalization. the countries assets theSamuelson currency; trademaintenance economy. foreignwhere stock allows to more depreciatedhave a higher inflation rate. CPI productivity the central will currency. associated with rises fasterbank to support the domestic currency. increase has a result the real appreciation of the domestic currency. The time series used 4.608 .8 4.607 .6 4.606 .4 4.605 .2 4.604 .0 4.603 4.602 -.2 4.601 -.4 1994 1995 1996 1997 1998 1999 2000 2001 1994 1995 1996 1997 1998 1999 2000 2001 LNRER LNTNT 5.0 8 4.9 6 4.8 4 4.7 2 4.6 0 4.5 -2 1994 1995 1996 1997 1998 1999 2000 2001 1994 1995 1996 1997 1998 1999 2000 2001 LNW NFA 3.6 3.2 2.8 2.4 2.0 1.6 1.2 0.8 1994 1995 1996 1997 1998 1999 2000 2001 OPEN Unit root tests In order to test the stationarity of time series I applied Perron’s tests (1994) Order of Level of Variables Integration Significance lnrer I(1) TC 1% lntnt I(1) TC 1% lnw I(1) TC 1% nfa I(1) T 1% open I(1) T 1% Lag Length Tests Lag LogL LR FPE AIC SC HQ 0 346.8935 NA 3.97E-10 -7.458281 -7.038848 -7.28922 1 947.1214 1092.55 9.68E-16 -20.38475 -19.26626 -19.93392 2 1008.546 104.9045 4.30E-16 -21.20328 -19.38573* -20.47068* 3 1034.986 42.18598 4.24E-16 -21.23565 -18.71905 -20.22128 4 1066.187 46.27517* 3.81E-16* -21.37499* -18.15934 -20.07885 5 1086.55 27.91319 4.44E-16 -21.27078 -17.35608 -19.69288 6 1115.5 36.4315 4.38E-16 -21.35955 -16.74579 -19.49987 7 1127.766 14.05728 6.49E-16 -21.07338 -15.76057 -18.93194 8 1150.519 23.52048 7.91E-16 -21.0229 -15.01103 -18.59969 Cointegration test Hypothesized Trace Critical value No. of CE(s) Eigenvalue Statistic 5 Percent 1 Percent None ** 0.427573 104.9282 68.52 76.07 At most 1 * 0.252823 53.60422 47.21 54.46 At most 2 0.180289 26.79056 29.68 35.65 At most 3 0.069478 8.500592 15.41 20.04 At most 4 0.020182 1.875694 3.76 6.65 Hypothesized Max-Eigen Critical value No. of CE(s) Eigenvalue Statistic 5 Percent 1 Percent None ** 0.427573 51.32398 33.46 38.77 At most 1 0.252823 26.81366 27.07 32.24 At most 2 0.180289 18.28997 20.97 25.52 At most 3 0.069478 6.624898 14.07 18.63 At most 4 0.020182 1.875694 3.76 6.65 Cointegrating relationship Normalization with respect to the real exchange rate yields the following cointegrating relationship: ln rer 4.680653 0.014566 ln tnt 0.022180 ln w 0.001637 nfa 0.016266 open (0.00362) (0.00702) (0.00067) (0.00269) .015 .010 .005 .000 -.005 -.010 -.015 1994 1995 1996 1997 1998 1999 2000 2001 Cointegrating relation Impulse Response Function Response to Cholesky One S.D. Innovations ± 2 S.E. Response of LNRER to LNRER Response of LNRER to LNTNT .0005 .0005 .0004 .0004 .0003 .0003 .0002 .0002 .0001 .0001 .0000 .0000 -.0001 -.0001 -.0002 -.0002 -.0003 -.0003 2 4 6 8 10 12 14 2 4 6 8 10 12 14 Response of LNRER to LNW Response of LNRER to NFA .0005 .0005 .0004 .0004 .0003 .0003 .0002 .0002 .0001 .0001 .0000 .0000 -.0001 -.0001 -.0002 -.0002 -.0003 -.0003 2 4 6 8 10 12 14 2 4 6 8 10 12 14 Response of LNRER to OPEN .0005 .0004 .0003 .0002 .0001 .0000 -.0001 -.0002 -.0003 2 4 6 8 10 12 14 Variance Decomposition Variance Decomposition Percent LNRER variance due to LNRER Percent LNRER variance due to LNTNT 100 100 80 80 60 60 40 40 20 20 0 0 2 4 6 8 10 12 14 2 4 6 8 10 12 14 Percent LNRER variance due to LNW Percent LNRER variance due to NFA 100 100 80 80 60 60 40 40 20 20 0 0 2 4 6 8 10 12 14 2 4 6 8 10 12 14 Percent LNRER variance due to OPEN 100 80 60 40 20 0 2 4 6 8 10 12 14 Weak Exogeneity Tests Variables χ2(1) Probability lnrer 0.8247 0,3697 lntnt 0,1666 0,6831 lnw 0,1733 0,6772 nfa 7.9714 0,0048* open 3.1030 0,0755 Short-Run Dynamics Vector error correction model, after imposing restrictions on the net foreign assets’ coefficients: ln rer 0.0257 [ln rer (1) 0.014566 ln tnt (1) 0.022180 ln w(1) 0.001637 nfa (1) 0.016266 open (1) 4.680563 ] 0.349784 ln rer (1) 0.448357 ln rer (2) 0.24764 ln rer (3) 0.002 ln tnt (2) 0.001887 lnw(1) 0.002275 lnw(-2) 0.001829 lnw(-3) 0.000369 open (2) 0.000364 dummy 97 0.000134 dummy 99 CONCLUSION The managed float exchange rate regime seems to be the most appropriate policy for Romania. This paper argues in favour of policies that will help increase the flexibility of wages and reduce the monopoly power in order to contribute to endogenous adjustment of the real exchange rate.

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posted: | 5/24/2010 |

language: | Romanian |

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