Published online by Cambridge University Press: 28 January 2010
Introduction
Real-exchange-rate (RER) misalignment refers to a situation in which a country's actual RER deviates from some notion of an implicit “ideal” RER. An exchange rate is labeled “undervalued” when it is more depreciated than this ideal, and “overvalued” when it is more appreciated than this ideal. Such misalignments are widely believed to influence economic behavior. In particular, overvaluation is expected to hinder economic growth, and undervaluation is sometimes thought to provide an environment conducive to growth. But unless the ideal is explicitly specified, the concepts of RER misalignment remain subjective. The objectives of this chapter are (1) to develop and construct explicit measures of RER misalignment and (2) to explore systematically the relationships between misalignment and economic growth.
Conceptually, an RER is misaligned when it deviates from the underlying RER that would have prevailed in the absence of price rigidities, frictions, and other short-term factors. A more structured definition of misalignment uses the notion of an “equilibrium RER.” This typically refers to the theoretical RER that would prevail if the economy were simultaneously in internal and external balance. “Internal balance” refers to the economy operating at full employment and at full-capacity output. “External balance” refers to a sustainable current-account position given a country's desired capital position as a net lender or borrower. RER misalignment can then be defined as the deviation of the actual RER from this equilibrium RER.
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