Assessing Interdependence Among Countries’ Fundamentals and its Implications for Exchange Rate Misalignment Estimates: An Empirical Exercise Based on GVAR^*

Abstract

Exchange rates are important macroeconomic prices and changes in these rates affect economic activity, prices, interest rates, and trade flows. Methodologies have been developed in empirical exchange rate misalignment studies to evaluate whether a real effective exchange is overvalued or undervalued. There is a vast body of literature on the determinants of long-term real exchange rates and on empirical strategies to implement the equilibrium norms obtained from theoretical models. This study seeks to contribute to this literature by showing that the global vector autoregressions model (GVAR) proposed by Pesaran, Schuermann, and Weiner (2004) can add relevant information to the literature on measuring exchange rate misalignment. Our empirical exercise suggests that the estimate exchange rate misalignment obtained from GVAR can be quite different to that using the traditional cointegrated time series techniques, which treat countries as detached entities. The differences between the two approaches are more pronounced for small and developing countries. Our results also suggest a strong interdependence among eurozone countries, as expected.

Keywords
Real effective exchange rate; cointegration; global VAR