A Model of Real Exchange-Rate Determination in Transition Economies

Abstract

The role of the exchange rate in the early phase of transition remains a source of debate among analysts and policymakers. At stake are important issues like the need to peg the exchange rate as a nominal anchor to control inflation, the risk of overvaluation, the effect of real appreciation on structural changes, the proper evolution of the current account, the reaction to capital inflows, speculative attacks, and, more generally, the conduct of monetary policy. Most analyses used in these debates are based, explicitly or implicitly, on theories developed for nontransition economies. Some argue that the relevant framework should be based on the experiences of developing countries, which, in common with transition, have fairly underdeveloped financial markets and trade barriers. Others observe that capital mobility is de facto quite high and trade barriers quite low, so that the proper reference is theories that fit developed economies. Yet the behavior of the exchange rate in transition economies exhibits some unique features that warrant separate theorizing.