Addressing Econometric Issues on How to Construct Theoretical Based Exchange Rate Misalignment Estimates : Searching for a Comprehensive Approach

Assessing real effective exchange rate equilibrium is a challenging task. There is no consensus in the literature on which methodologies and norms apply best to tackle real effective exchange rate misalignment estimation. The novelty of our paper consists of showing that different methodologies to assess exchange rate misalignment can be conciliate if a proper well specified and congruent econometric model that satisfies economic based restrictions is analyzed. Under these circumstances it is possible to decompose exchange misalignment into economic meaningful pieces. We criticized Behavioral Equilibrium Exchange Rate approach (BEER) for disregarding a priori trade balance information in a econometric model designed to assess exchange rate misalignment and rely only on net foreign asset and a selected set of fundamentals information. The following points are addressed in the paper: i) explore and test over identifying restrictions implied by economic theory to strength exchange rate misalignment estimates; ii) decompose exchange rate misalignment estimates into economic meaningful pieces; iii) discuss under what conditions trade balance information can help to improve exchange rate assessment using BEER approach; iv) propose a methodology to disentangle what are the sources of differences in exchange rate misalignment estimates by adapting Blinder-Oaxaca decomposition (Blinder, 1973; Oaxaca, 1973) to our problem and v) collect evidence that real effective exchange rate, trade balance and net foreign asset position are cointegrated with more than one cointegrated vector for a group of OECD and emerging market economies. Finally we illustrate possible advantages of our approach by analyzing the Brazilian and Australian cases in detail. In the first case, trade balance information plays an important role in exchange rate assessment. Fundamental Equilibrium Exchange Rate approach (FEER) that focus on current account information to assess exchange rate misalignment and BEER approach provide complementary information to explain exchange rate in the long run. For Australia, real effective exchange does not react strongly to trade imbalances and BEER plays the leading role