The Determination of the Real Exchange Rate and its Effects on Output and Prices in Slovenia

Abstract

The most intriguing question in defining the equilibrium real exchange rate is to determine which actual exchange rates are in line with their fundamentals. In an attempt to provide an answer to this question, two main definitions of the equilibrium exchange rate have been widely used (Clark, 1996). The first characterizes the equilibrium exchange rate as a desirable real exchange rate consistent with an ideal macroeconomic performance establishing internal and external balance. Internal balance is defined as the level of economic activity that keeps the inflation rate constant. The external position is balanced if the external current account can be regarded not only as sustainable, but also as appropriate based on desired levels of savings and investment. In this sense, the fundamental (desirable) equilibrium real exchange rate measure is a normative one. On the other hand, the natural real exchange rate is a positive concept that involves the specification and estimation of an equation that explains the actual movements of the real exchange rate in terms of changes in economic fundamentals. The most important ones are productivity and thrift. The distinctive characteristic of both definitions is, therefore, definition and characterization of the fundamentals of the real equilibrium exchange rate. While the first concept attempts to find desirable and potential economic variables, the second concept simply concentrates on the actual movements of the determinants of the real exchange rate. The concept of an equilibrium real exchange rate is especially delicate in transition economies.