ABSTRACT
The real exchange rate plays an important role in resource allocation and economic growth in developing countries. 1 Real-exchange-rate misalignment 2 therefore impacts significantly upon resource allocation and economic growth. Policy-makers in developing countries also consider real-exchange-rate stability necessary for maintaining macroeconomic stability. Real exchange rates, however, are beyond the direct control of policy-makers, since they are determined endogenously, both by domestic and by external factors. Although in the long run they may be stable with or without trend, in the short run real exchange rates are volatile, responding sensitively to changing relativities, flexibilities and rigidities in domestic and external prices, wages and nominal exchange rates. The problem of understanding the factors that determine both the short-run (current) value of the real exchange rate, and its long-run equilibrium, has therefore emerged as an important area of research in international trade and finance (Edwards, 1989a; Krugman and Obstfeld, 2010).
