An exchange rate, the price of one country’s currency expressed in units of another, shapes how expensive a country’s goods and services are for the rest of the world, and how affordable imports are at home. When the exchange rate is at the right level, it helps keep trade balanced and gives businesses and investors a reliable signal for their financial decisions. But exchange rates can be knocked off course. A global financial crisis, a sudden drop in commodity prices, or a major policy change can all cause a currency’s value to move sharply and unexpectedly. When that happens, it is often unclear whether the shift is short-lived or reflects something more deep-rooted in the economy. Either way, the consequences can be significant: a country may become less competitive, resources may be inefficiently allocated across sectors, and growth and stability can suffer.
To get a clearer picture of whether a currency is misaligned, economists look at the real exchange rate (RER). Unlike the nominal exchange rate, the RER adjusts for differences in price levels between countries, making it easier to judge whether a currency is overvalued or undervalued relative to where it should be. For policymakers, the key question then becomes: How quickly will the exchange rate correct itself and return to a sustainable level?
A new paper, offers an alternative way of measuring real exchange rate misalignments. Instead of assessing how quickly exchange rates return to a fixed equilibrium exchange rate, it estimates how quickly exchange rates return to a RER equilibrium that evolves over time with economic fundamentals. This dynamic perspective offers a different view of exchange rate adjustment, suggesting that exchange rates may return to equilibrium faster than commonly believed (see Figure 1). These findings have important implications for how policymakers assess exchange rate movements and design policy responses.
