An Empirical Study Of The Equilibrium Real Exchange Rate Of China's Yuan

Within open economic system, exchange rate represents the purchasing power of domestic currency. Not only does exchange rate directly determine the level of the purchasing power of domestic currency on the spot, but also causes revaluation of domestic properties, which makes exchange rate one of the monetary policy tools and be used as a major tool to export liquidity more and more frequently. During recent years, accompanying the increasing pressure on Renminbi (RMB) appreciation, RMB exchange rate has gradually obtained great amount of attentions from scholars inside and outside China and generated a lot of discussions on the reform of RMB exchange rate mechanism and the ideal or the real exchange rate among many economists.This paper uses Behavioral Equilibrium Exchange Rate (BEER) model within the framework of Equilibrium Exchange Rate (EER) theory for developing countries, chooses a set of fundamental economical factors that are in agreement with China economy realities, constructs an RMB EER model, then implements co-integration techniques, error correction model and Hodrick-Prescott filter to estimate RMB EER level and correspondent misalignment, finally analyzes the RMB exchange rate misalignment since the 1980s, and provide some policy recommendations on exchange rate under current economic situation.This paper consists of five chapters:The first chapter summarizes the subject of this paper and relevant background, and outlines our research approach and major contribution.In the second chapter theoretical works on BEERs as well as specific studies on RMB EER were summarized and reviewed. Through the study, we believe that combining BEER theory and EER theory for the developing countries is the most suitable for China's current economic characteristics, not only because it takes into account the endogeneity of EER and fundamental economical factors' decisive impact on EER in mid- and long term, therefore the results are closer to economic realities, but also because it mainly uses co-integration to establish the whole empirical formula, which reduces the workload and improves the reliability of the model estimates.The third chapter outlines the concept and related theories of equilibrium real exchange rate. First of all, the concepts of nominal exchange rate and real exchange rate are introduced, the classification and measurement methods of real exchange rate are described. In addition, we introduce the concept of equilibrium exchange rate and analysis the meaning of equilibrium exchange rate within macroeconomic equilibrium. In this chapter we also summarize EER theories, and discuss the development, contents and corresponding measurement methods of various EER theories in order to obtain an overview.Chapter Four, probably the most important among all the chapters, provides an econometric study on RMB EER using empirical data. Before the details of our study, we briefly introduce various econometric methods used in this paper, which include ADF test, Granger causality test, co-integration test, error correction model and Hodrick-Prescott filter. For our purpose, an RMB EER model is constructed based on BEER and EER for developing countries, and a set of fundamental economical factors that fit China economy reality are chosen for the model. Annual data from 1980 to 2006 are used as sample. Stationarity is tested for all six economic factors (real effective exchange rate, productivity, foreign reserve, government expenditure, openness and real money supply) through first order differentiation and ADF test, and we conclude that the first order differentiation series of factors are first order unit interation series and co-integration test can be conducted. Granger causality test shows the variations of productivity, foreign reserve, government expenditure, openness and real money supply could cause the change of RMB real effective exchange rate (REER), therefore further investigation into these five factors' impact on RMB REER is justified. To study the long-term equilibrium relationship between those five fundamental economic factors and REER, co-integration test and error correction model are used on the sample and we find the standardized co-integration formula:REER=6.4078+1.2743LPROD+0.5597LFR+2.1613LGOVG-0.8075LOPEN-1.6865LRM₂and error correction model:△LREER=0.16[LREERF_t-1-LREER_t-1]+0.52△LPROD_t-1+0.24△LFR_t-1+0.47LGOVG_t-1-0.11△LOPEN_t-1-0.62△LRM2_t-1-0.257From the formula above, we can see short-term variations of fundamental economic factors have the same impact on exchange rate as long-term ones, i.e. no matter it's short- or long-term, the improvement of productivity, expansion of government expenditure and accumulation of foreign reserve will increase the pressure on currency appreciation, while expansive monetary policy and further openness will depreciate real exchange rate. In the last part of our empirical study, we use Hodrick-Prescott filter to estimate RMB REER and correspondent misalignment with nominal exchange rate and systematically compare the undervalue and overvalue regimes of RMB exchange rate between 1980 and 2006.Chapter Five, the last chapter, based on our empirical results and current economic conditions, provides a few recommendations for the development of the exchange rate policy: the exchange rate policy, capital market and monetary policies are inextricably linked; the size and quality of the economy determine the value of RMB; while strengthening management of foreign fund inflow and foreign exchange remittance, we should prevent the shock of short-term capital flows. This paper also lists the impact of RMB appreciation pressure at the macroeconomic level in order to provide practical advices on RMB exchange rate problem under current circumstances.