A study of the equilibrium real exchange rate of the Maltese lira

Abstract

This study provides the theoretical background and empirical investigation that are essential for the estimation of the equilibrium real exchange rate (ERER) for the Maltese lira. The real exchange rate is the nominal exchange rate adjusted for domestic and international price levels while the ERER is the rate to which the real exchange rate tends over the medium to long term. Although not known directly, the ERER can be estimated under a number of assumptions. Some of these assumptions refer to the circumstances that need to prevail for the equilibrium to occur, others to the relation between the real exchange rate and economic fundamentals. In this study it is the equilibrium over the medium run that was of interest, since in the long run real adjustment is probably inevitable, even in the absence of corrective policy. The estimation of the ERER signals possible exchange rate misalignment and is therefore an essential input into the identification of the appropriate level of the Maltese lira exchange rate.