Real exchange rate misalignment and macroeconomic performance in open economies: Analysis on selected emerging market economies

Traditional view acknowledges the detrimental impact of Real Exchange Rate (RER) misalignment on the macroeconomic performance of open economies from the long-term perspective. Findings of the earlier studies on the impact of RER misalignment on macroeconomic performance could be misleading as they typically rely on panel data methods in deriving misalignment series which is highly criticized for its strong homogeneity assumption. Moreover, they mostly investigate the growth performance of open economies in response to RER misalignment while dynamics in fundamentals like trade balance, the aggregate level of domestic consumption and domestic investment are also important to draw more inclusive decision. The study first estimates the equilibrium RER and RER misalignment of selected emerging market economies (EMEs) distinctly adopting single equation approach to confirm the heterogeneity of RER behavior in the long-run through 1980-2016 and then examines its impact on macroeconomic performance of the EMEs together with the respective impact of undervaluation and overvaluation employing Blundell & Bond's (1998) System Generalized Method of Moments (SGMM) estimation approach. Results suggest that RER misalignment and its two opposing components- undervaluation and overvaluation hurt the growth of EMEs. Again, the anti-growth effect of undervaluation is later supported by consumption regression as it finds that undervaluation dries up aggregate consumption. The impacts of undervaluation and overvaluation on the trade balance and domestic investment are in line with theoretical claims- undervaluation stimulates trade surplus and domestic investment while overvaluation erodes them. However, RER misalignment helps recover trade imbalances and promotes aggregate domestic investment. Considering the implications of RER misalignment on economic activity, avoiding distortion in RER from its long term equilibrium level is a crucial policy concern for emerging economies. Keywords: Real Exchange Rate Misalignment, Single Equation Approach, SGMM, Emerging Market Economies.