The Measurement And Application Of RMB Equilibrium Exchange Rate

As the most important overall price index in economy, exchange rates are justifiably a major focus not only for academic but policymakers. They affect output and employment through real exchange rates; they affect inflation through the cost of imports and commodity prices; they affect international capital flows through the risks and returns of different assets. With the deepening of the world economy integration, exchange rates play an essential role in economic activities, domestically and internationally.Given the opening up of China’s economy and high degree of the trade dependence, the RMB exchange rate has increasingly become the focus of attention. Especially with the speed up of the reform of the RMB exchange rate regime, it would be hard to overstate the importance of the equilibrium level of RMB exchange rate. Consequently, the measurement of equilibrium RMB exchange rate and the extent of following misalignments are related to an accurate and reasonable evaluation of China’s exchange rate polices, providing solid foundation for the future reform of China’s exchange rate regime.In this paper, we estimate the equilibrium RMB exchange rate and corresponding misalignment. In the theoretical aspects, we emphasize on modeling exchange rates in the context of both general equilibrium models and purchasing power parity (PPP). More importantly, we expand the traditional purchasing power partiy with two ways, namely the Balassa-Saumuelson effect and the nonlinearity in the adjustment to equilibrium level. Furthermore, we analyze the relationship between RMB exchange rate the China’s economic growth.In summary, our results based on the BEER model using co-intetraton and error-correcting technics show that RMB exchange rate does not devaluate obviously, and it has been near its equilibrium level band. Our non-linear model that incorporates the BS effect can account for the persistence of deviations from PPP, providing strong evidence of nonlinearity in RMB. We also find that empirically China’s trade balance is sensitive to RMB exchange rates, but the size of the surplus is such that exchange rate policy alone will be unable to address the imbalance.