EQUILIBRIUM EXCHANGE RATE OF THE ESTONIAN KROON, ITS DYNAMICS AND IMPACTS OF DEVIATIONS Fabio Filipozzi Tallinn 2000 Working Papers of Eesti Pank No 3, 2000

The aim of the analysis presented here is to examine the behaviour of the real exchange rate of the Estonian kroon, to estimate its equilibrium value and investigate its impact on the competitiveness of Estonian economy.
A brief account on possible measures of the real exchange rate (RER) is given, and then the real effective exchange rate (REER) weighted with domestic and foreign consumer price indices (CPI) is chosen for the estimation. A model for the equilibrium real exchange rate (ERER) determination suitable for a small open economy as Estonia is outlined and provides a theoretical basis for understanding what kind of fundamentals can affect real exchange rate behaviour.
Given the short sample considered here, a single equation estimation method is used. The choice of fundamentals is determined both by particular features of the Estonian economy and data constraint. The fundamentals finally adopted are productivity differential between tradeables and nontradeables sectors, investment share, resource balance and nominal effective exchange rate. Having detected the existence of one cointegration vector between RER and fundamentals, it is possible to estimate the long-run relationship linking them and an error correction mechanism in order to have some information on short-run behaviour of the real exchange rate.
Estimation results are then used to construct both ERER series and misalignment measures. To do this, some hypotheses on equilibrium/sustainable levels of fundamentals are set and discussed. Our simulation hence brings us to conclude that an appreciation of RER in the sample period occurred together with an appreciation of its equilibrium level. The latter appreciated slower, hence the initial undervaluation was corrected and the difference between RER and its equilibrium level shrank, leading to a slight overvaluation after the Russian crisis.

Author Fabio Filipozzi (e-mail: fabio_filipozzi@yahoo.com), Master in Economics, Bocconi University (Milan) was a guest researcher at Eesti Pank in 2000.

The views expressed in this paper are those of the author and do not necessarily reflect the official view of Eesti Pank.

Table of Contents

Introduction

SECTION 1

1.1 REER measures

SECTION 2

2.1 Models of Equilibrium Real Exchange Rate

PPP

Single equation specification

Partial equilibrium models

General equilibrium models

2.2 Some implications of the euro for the outside world

2.3 Effects of fundamentals on ERER

SECTION 3

3.1.Estimation method

3.2 Variables

3.3 Cointegration

3.4 Estimation result

3.5 Equilibrium

Conclusion

Appendix 1: Model

Appendix 2: Data and Sources

Appendix 3: Tables

Appendix 4: Figures

Literature

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