User talk:Razaxagha

Conceptual Underpinnings Given resource scarcity and the case for specialization, a country exports and imports various commodities/services reflecting the optimizing economic decisions of its economic agents. This trade of goods and services is best captured in the current account, which is a statistical record of a country’s economic relations with the rest of the world. It indicates the extent to which a country’s economic agents (the government, firms and individuals) are net borrowers or net lenders compared to their economic partners. Thus, the current account balance is an important indicator of the balance of resources used in an economy.

Since the transactions recorded under the current account deficit are a function of prices (amongst other things), optimizing agents are assumed to response to price changes. More broadly, local agents must procure foreign currency if they are to utilize a non-domestic resource. The exchange rate thus becomes one of the most important prices in an open economy, measuring domestic purchasing power relative to the rest of the world. However, the true value of a country’s exchange rate must account for the inflation domestically and inflation internationally to determine the real purchasing power of the local currency. Once these inflation differentials are accounted for, the Real Effective Exchange Rate (RER) emerges.

The term effective is used to indicate that the exchange rate is trade weighted. By definition, this effectiveness must be against specific countries, whose bilateral exchange rates are used to compute the REER Index. The countries can be chosen in several ways, including: bilateral trade (exports and imports), either the most recent numbers or recent averages; just exports or just imports; a specific export commodity, such as industrial goods; or, looking at the home country’s export competitors. In terms of the latter, specific categories of competitors can also be looked at; for instance, emerging market competitors, developed country competitors, etc.

Mathematically then, the REER is essentially an index based on the ratio of foreign and domestic prices used to approximate the real exchange rate: (r/r*).(p/p*), where r is the domestic exchange rate in units of foreign currency; r* is a composite of trading partner exchange rates, p is the domestic price index, and p* is the foreign price index. It is the most basic measure of a country’s competitiveness in inflation adjusted terms. The latter is important since inflation in the domestic economy may erode the country’s export competitiveness, and hence reduce the value of the domestic currency vis-à-vis its competitors.

An example will best demonstrate this: if the exchange rate depreciates by 5 percent, and domestic prices also rise by 5 percent, then the competitiveness of the home country’s export goods is not changed. Alternatively, if depreciation amounts to say 10 percent, while prices rise only 5 percent, then local goods have become more competitive, since an equivalent amount of the local currency, now buys 5 percent more goods (all else equal). Thus, the theory of purchasing power parity states that the domestic exchange rate should adjust to compensate for changes in relative prices or trading partner exchange rates such that the real exchange rate is in equilibrium. It is here where the relevance for policy makers and researchers emerges: will adjusting the exchange rate rectify the current account or trade deficit?

There are two ways to answer the above question. One, it depends on the relative export and import price elasticities (Marshall-Lerner condition). Two, if the current account is taken to be the difference between national income and domestic absorption (public/private consumption/investment), then a devaluation will affect the current account balance directly through its impact on real income and absorption, and indirectly by affecting the income elasticity of absorption (change in absorption in response to a change in income).

Before presenting the actual method to calculate the REER, it should be noted that the choice of base year, trade weights, and price index used does impact the outcome. Hence, it is possible to show more or less over or undervaluation if the exchange rate. Thus it is important to identify the purpose in calculating the REER: are we measuring overall competitiveness, the competitiveness of a particular industry, competitive at the consumer, whole-sale or another price level.

Since the purpose of this appendix is to evaluate the competitiveness of Pakistan’s exports, it calculates the REER index on the basis of the country’s exports, and her competitors in these export markets. The need for such an evaluation arises on account of recent developments: while Pakistan’s CPI inflation stood at 3.1 percent in FY03, 4.6 percent in FY04, and 9.3 percent in FY05, the exchange rate has appreciated by 0.42 percent over the same period. This implies that the Rupee should have become overvalued.