Real exchange rates, trade, and macroeconomic performance: The case of Cameroon, including relevant comparisons

The exchange rate is an important instrument of economic policy. It has played a prominent role in the development strategy of many developing countries. It has also been an important instrument of macroeconomic stabilization. This dissertation attempts to assess the impact of real exchange rate misalignment on the economy of ten Sub-Saharan Africa countries from 1960 to 1994. Real exchange rate is defined as the price of tradables to nontradables. In this study we define real exchange rate misalignment as a short-run deviation from the long-run equilibrium exchange rate. We use error correction model which allows for short-run movements while imposing gradual adjustment toward equilibrium value to capture the short-term dynamics of the real exchange rate behavior. The residual from the cointegrating vector is used as a measure of real exchange rate misalignment. This represents an improvement over the traditional definition and reveals important insights about the causes of real exchange rate misalignment. We test the hypothesis that real exchange rate misalignment is a major cause for the poor economic performance in Sub-Saharan Africa. To test this hypothesis we use vector autoregression (VAR) model with time series and panel data. The results show that real exchange rate misalignment has a deleterious effect on key macroeconomic variables such as growth and exports. Both the variance decomposition of prediction errors and the impulse response functions indicate that real exchange rate shows and explains a significant part of the poor economic performance of Sub-Saharan countries. But what causes exchange misalignment? Causality tests using vector autoregression (VAR) with individual country time series and panel data suggest that a boom in investment caused an appreciation of the currency. This in turn created a boom in constructions. This in turn drove the wages up as well as the inflation. Consumption of tradable goods has consequently declined. An increase in demand exports crowded out net exports, and so caused a decline in GDP growth rate in those Sub-Saharan countries. The result seems to be consistent with those obtained using the tradable and nontradable (TNT) model or the traditional IS-LM model. In either case the results can be satisfied. This appears to hold true both for the floating exchange rate regime and the fixed exchange regime. These findings lead to important observations. Causality runs more from real variable (investment) to misalignment rather than vice-versa. The error correction model suggests that some percentage of the discrepancy between the actual and the equilibrium value of the real exchange rate will be corrected in two years. The findings of this study together with the fact that boom in investment causes RER misalignment both in the fixed and flexible exchange rate regimes underlie these countries\u27 dependence on the rest of the world as far as monetary and fiscal policy are concerned