The Study Of RMB Equilibrium Real Exchange Rate

Equilibrium exchange rate is critically important for international economy. The problem of exchange rate misalignments and the resulting payments imbalances have plagued the world economy for decades. If we know the exact equilibrium exchange rate, we can calculate the misalignment so that we would use right methods to improve the condition. Since July 2005, China began to implement a new exchange rate system, i.e., management floating exchange rate system that based on market supply and demand, and with reference to a basket of currencies. It shows that the RMB exchange rate will no longer be pegged to the U.S. dollar, but become more flexible. As well known, in a floating exchange rate system the exchange rate is automatically adjusted by the market mechanism, while in a managed floating exchange rate system to maintain exchange rate stability depends on the government's macro-control. Therefore, only fully aware of the change in the trend of the equilibrium exchange rate, we could deal with the exchange rate management more effectively.The purpose of this paper is to find out an appropriate theory, based on which we could do further study on the long-term equilibrium exchange rate of RMB and calculate the exchange rate misalignment.This paper is organized as follows: we first present a critical overview of earlier equilibrium exchange rate determination methods. Then four theories are summarized to find out a suitable equilibrium exchange rate model for Chinese current conditions. In the following part, Behavioral Equilibrium Exchange Rate theory and Real Interest Differential model are used separately to study RMB real effective exchange rate and RMB real exchange rate. In the meanwhile, some empirical methods such as Johansen's Co-integration test, Hodrick-Prescott Filter and Vector Error Correction model are used to investigate the long-term equilibrium relationship between the RMB real exchange rate and the fundamental economic factors. The result shows: During the period of Asian financial crisis, the RMB real exchange rate is overvalued. After July 2007, the under-estimation of RMB real exchange rate is shortened. It also proves the correction and timeliness of the new exchange rate system. During the period of 1997 to 2007, the most significant misalignment is no more than 10%.