The real exchange rate measures the relative price of domestic goods and services compared to foreign ones. A high real exchange rate means that domestic goods and services are expensive relative to foreign ones, which can hurt exports and growth. A low real exchange rate means that domestic goods and services are cheap relative to foreign ones, which can boost exports and growth.

But what determines the real exchange rate of a country? What are the factors that affect its movements over time? In this blog post, we will summarize a recent academic article1 that answers these questions for Algeria, a country that relies heavily on oil exports and faces many economic challenges.

How do they measure Algeria’s real exchange rate?

The authors use the real effective exchange rate (REER) as a measure of Algeria’s real exchange rate. The REER is calculated as the nominal effective exchange rate (NEER), which is the weighted average of the bilateral exchange rates of Algeria with its main trading partners, adjusted by the inflation differential between Algeria and those countries. The REER captures both the nominal movements of the exchange rate and the changes in the price levels.

How do they identify Algeria’s real exchange rate determinants?

The authors use cointegration techniques to test for a long-term relationship between Algeria’s REER and a set of fundamental variables that are expected to affect it. These variables include:

• The terms of trade: the ratio of export prices to import prices. A positive shock in the terms of trade, such as an increase in oil prices, can appreciate the REER by increasing the purchasing power of domestic income.
• The productivity differential: the ratio of labor productivity in Algeria to labor productivity in its trading partners. A positive shock in the productivity differential, such as an improvement in technology or human capital, can appreciate the REER by increasing the demand for domestic goods and services.
• The government consumption: the ratio of government spending to GDP. A positive shock in government consumption, such as an expansionary fiscal policy, can appreciate the REER by increasing the demand for domestic goods and services.
• The investment: the ratio of gross fixed capital formation to GDP. A positive shock in investment, such as an increase in public or private investment, can depreciate the REER by increasing the supply of domestic goods and services.
• The development of the banking system: measured by the ratio of credit to GDP. A positive shock in the development of the banking system, such as an improvement in financial intermediation or inclusion, can depreciate the REER by increasing the supply of domestic goods and services.
• The trade openness: measured by the ratio of exports plus imports to GDP. A positive shock in trade openness, such as a reduction in trade barriers or costs, can depreciate the REER by increasing the competition and efficiency of domestic producers.

What do they find?

The authors find that there is a long-term relationship between Algeria’s REER and its fundamental variables. They estimate that a 1% increase in:

• The terms of trade leads to a 0.31% appreciation of the REER
• The productivity differential leads to a 0.25% appreciation of the REER
• The government consumption leads to a 0.18% appreciation of the REER
• The investment leads to a 0.23% depreciation of the REER
• The development of the banking system leads to a 0.19% depreciation of the REER
• The trade openness leads to a 0.16% depreciation of the REER

They also find that there is a short-term adjustment mechanism that corrects any deviation from this long-term relationship.

What are the implications?

The authors discuss some implications of their findings for Algeria’s economic performance and competitiveness. They argue that Algeria’s REER has been overvalued for most of the period under study, especially after 2000, due to positive shocks in its terms of trade (oil prices) and government consumption (public spending). They suggest that Algeria should adopt a more flexible and competitive exchange rate regime, along with other structural reforms, such as diversifying its economy, improving its productivity, developing its banking system and enhancing its trade openness.

Conclusion

In this blog post, we have summarized a recent academic article that investigates the determinants of the real exchange rate in Algeria from 1970 to 2016. The article finds that investment, development of the banking system and trade openness are significant determinants of Algeria’s real exchange rate. The article also finds that Algeria’s real exchange rate has been overvalued for most of the period under study, and suggests that Algeria should adopt a more flexible and competitive exchange rate regime.

We hope you found this blog post informative and interesting. If you want to learn more about this topic, you can read the full article or check out other articles from Revue des Sciences Economiques et Commerciales, a biannual journal publishing original research and theoretical debates on economics and business.