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GALLERY: Exchange Rate

There is evidence that the RER generally reaches a steady level in the long-term, and that this process is faster in small open economies characterized by fixed exchange rates. Any substantial and persistent RER deviation from its long-run equilibrium level, the so-called RER misalignment, has shown to produce negative impacts on a country’s balance of payments. An overvalued RER means that the current RER is above its equilibrium value, whereas an undervalued RER indicates the contrary. Specifically, a prolonged RER overvaluation is widely considered as an early sign of an upcoming crisis, due to the fact that the country becomes vulnerable to both speculative attacks and currency crisis, as happened in Thailand during the 1997 Asian financial crisis. On the other side, a protracted RER undervaluation usually generates pressure on domestic prices, changing the consumers’ consumption incentives and, so, misallocating resources between tradable and non-tradable sectors.

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