Chapter 4: Exchange Rate Misalignment
THE CONCEPT OF MISALIGNMENT The US trade deficit with China is typically attributed to undervaluation of the yuan (hence overvaluation of the dollar). In February 2009, the then managing director of the IMF, Dominique Strauss-Khan, made the undervaluation of the yuan an undisputable fact of life, describing it as “common knowledge”. The Economist (2009a) correctly argues that “you would assume that such strong claims were backed by solid proof, but the evidence is, in fact, mixed”. In July 2011, The Economist (2011a) changed its long-held view that the yuan is undervalued by announcing that its modified Big Mac index shows that the yuan is not undervalued against the dollar. When a currency is overvalued or undervalued, the exchange rate is said to be misaligned. Therefore, exchange rate misalignment is the deviation of the actual exchange rate from its long-run equilibrium level as determined by economic “fundamentals”. Measuring misalignment is difficult and inherently imprecise, as it requires estimation of the equilibrium exchange rate, which is not observable. Given the miserable state of exchange rate economics, we simply do not know which fundamentals affect the exchange rate and how they do that (for some, exchange rates are determined by aliens from distant galaxies). Furthermore, when misalignment refers to the real exchange rate, even the actual rate becomes unobservable, as the real exchange rate depends on the price indices used to measure it (the real exchange rate is measured by adjusting the nominal exchange rate for the prevailing price levels in the countries...
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