Estimating the Equilibrium Exchange Rate of the Central and Eastern European Acceding Countries: The Challenge of Euro Adoption
Review of World Economics (Weltwirtschaftliches Archiv), Vol. 139, No. 4, pp. 683-708
Posted: 27 May 2003
The ambition of this study is to estimate the equilibrium real and nominal exchange rates for 5 selected Central and Eastern European transition economies, namely for the Czech Republic, Hungary, Poland, Slovakia and Slovenia. For this purpose, the fundamental equilibrium exchange rate (FEER) methodology developed by Williamson (1994) is combined with the behavioural equilibrium exchange rate (BEER) approach advocated by Clark and McDonald (1998). Our investigation is based on the notion of internal and external balances defined respectively in terms of the relative price of non-tradable goods and the long-run sustainability of the current account position, and is carried out in the framework of a VAR-based 3-equation cointegration system. Long-term equilibrium values for relative prices are determined using relative productivity and private consumption, whereas the current account is regressed on terms of trade and the openness ratio. To derive the equilibrium real exchange rate and to compute subsequently the extent of misalignment, the long-run values for external and internal balances are substituted in the simultaneously estimated cointegration relationships connecting the real effective exchange rate with relative prices and the current account. The empirical findings show that the gap between the observed and estimated equilibrium real exchange rates differs across the 5 transition countries: the Czech Republic, Poland and Slovakia may have experienced an excessive appreciation of their real effective exchange rate whilst Hungary and Slovenia show little sign of overvaluation during the period under study. These results suggest the role flexible exchange rate regimes may play in exchange rate misalignments. Assuming that the obtained misalignment can be eliminated with adjustments in the nominal exchange rate, the estimated misalignment is used to derive the equilibrium nominal exchange rate against the euro. Finally, we construct a hypothetical ERM-II so as to investigate the nominal exchange rate stability around the estimated equilibrium nominal exchange rate.
Note: This is a description of the paper and not the actual abstract.
Keywords: Transition, Central and Eastern Europe, Real Exchange Rate, Cointegration
JEL Classification: E31, F31, O11, P17
Suggested Citation: Suggested Citation