The determinants of real exchange rate: theory and evidence from Papua New Guinea

This paper examines the determinants of real exchange rate in Papua New Guinea employing annual data for the period 1970-1994. The theoretical framework for the analysis is provided by the two goods (tradable and nontradable) dependent economy (Australian) model modified in the light of recent theoretical advances of macroeconomic modelling of external shocks in developing countries. In this dynamic model of the real exchange rate both real and nominal determinants of real exchange rate misalignment are studied, with emphasis on macroeconomic policy and nominal devaluation, along with other explanatory variables suggested by the theory. The findings are generally consistent with the predictions of the model. They suggest that nominal devaluation plays a major role in determining real exchange rate behaviour, whereas an improvement in external terms of trade seems to have no long run effect on the trade-weighted real exchange rate. Net capital inflow, foreign aid, trade restrictions and expansionary macroeconomic policies tend to cause the real exchange rate of Papua New Guinea to appreciate.