Real and nominal effective exchange rates in MENA countries: 1970–2004

Abstract

The main purposes of this article are 3-fold. First, we construct measures of real and nominal effective exchange rates for 14 Middle East and North African countries over the 1970–2004 period. Second, we test the validity of the Purchasing Power Parity (PPP) by applying the ADF and KPSS tests to the real effective exchange rates. Finally, we employ the bounds testing approach to cointegration and error-correction modelling to show that nominal devaluation leads to real devaluation in the short-run as well as in the long-run in many of the countries.

Notes

¹ To simplify, Ghosh et al. (1995) suggest hard pegs work best, while Levy-Yeyati and Strurzengger (2003) suggest floats do. Reinhart and Rogoff (2002) suggest limited flexibility performs best.

² The latter is a particular concern in LDCs where missing markets prevent affordable hedging, which can discourage trade and investment. Hedging cuts the premium/margin/spread between borrowing and lending and thus is critical in countries where investment has been sub-optimally low and is needed to boost growth. For details, see Rose (2000).

³ A considerable level of skill is needed for an independent monetary policy. Monetary policy, in a floating regime, can be used in the short run to affect the exchange rate in line with the objectives of monetary policy.

⁴ See McKinnon (2000) on the costly holding of reserves. Nonetheless, some countries with de facto floats are holding historically very high reserves. While countries may be able to generate interest on foreign reserves, the domestic economy does not see the benefits of these reserves. The opportunity cost of holding reserves increases if domestic growth is slow and/or there is a need to diversify the economy.

⁵ Example of studies that have tested the PPP for different countries using unit root or cointegration analysis are Taylor (1988), Corbae and Ouliaris (1988, 1991), McNown and Wallace (1989), Layton and Stark (1990), Bahmani-Oskooee and Rhee (1992), Bahmani-Oskooee (1995b),Ahking (1997), MacDonals (2002), Peel (2003),Jenkins (2004) and Narayan (2005). For a debate and review article on the PPP see Taylor and Taylor (2004) and Taylor (2003). For a few other studies that have used different approaches in testing the PPP see Bwo-Nung (1996),Nachane (1997),Carrion-I-Silverstre et al. (2004) and Enders and Chumrusphonlert (2004).

⁶ Outlined by their Equation 13 on p. 165.

⁷ Note that since data are annual, we imposed maximum of four lags on each first differenced variable.