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So far, the empirical evidence about the relationship between trade openness and the REER has been mixed.This may partly be due to the operationalization of trade openness.
This paper contributes to our knowledge about its determinants in a number of ways, mostly related to methodological aspects.
Since the empirical studies have shown mixed results depending on the countries that have been studied, we use a methodological approach that does not restrict the slope coefficients of the independent variables to be the same for each country.
If this level is low, a decrease in tariffs will produce a real depreciation, as a substitution effect will dominate (i.e., the price of nontradables will diminish relative to that of exports).
But if the liberalization occurs with a large initial level of tariffs, there may be an increase in welfare (income effect), which may produce an excess demand for nontradables and their price will go upwards.
In some countries, problems of overappreciation of the REER cannot be simply solved by means of a nominal devaluation because of limits to monetary policy (e.g., countries that use the Euro as a monetary unit; Ecuador whose monetary unit is the US dollar, etc.). The explanation of the relationship between trade openness and the REER is that when the real effective exchange rate appreciates, domestic products become more expensive for the rest of the world, and therefore their demand decreases.
Our study suggests a viable alternative as there are several economic measures that can be readily taken by the economic policy maker to increase trade openness and thus generate a depreciation of the REER. On the other hand, an overappreciated exchange rate makes foreign tradable products become cheaper than domestic ones, which increases imports unless the government raises their cost through tariffs or restrict their entrance by other means (e.g., quotas).The study of the determinants of the real exchange rate is a topic that has received much attention in international economics.The first theoretical approach to its conceptualization dates back to Cassel’s () thesis, which stated that there is an equilibrium exchange rate for money across different countries and that the exchange rate should converge to this value regardless of temporary fluctuations (i.e., appreciation or depreciation due to different inflation rates).As alternative indicators of trade openness, we have also used (1) the import penetration ratio (imports as a share of GDP), which has been utilized by Romelli et al.(), which is the difference between a country’s actual trade volume and its theoretical trade volume estimated as a function of its size and other structural characteristics.Thus, protectionism through tariff barriers, quotas or other forms restricts imports and consolidates a situation of REER appreciation.Therefore, many authors have argued that trade liberalization leads to the opposite effect, a depreciation of the REER.Given the existence of long-term deviations from PPP in some countries, scholars were interested in explaining these deviations; and those who believed that PPP theory does not hold attempted to identify the factors behind appreciations or depreciations of the real exchange rate.So far, the studies on this subject are not conclusive about the particular factors that affect the real effective exchange rate (REER).Omitting the consideration of cross-sectional dependence leads to a potentially severe bias in the regression coefficients; and our methodological strategy deals effectively with this problem, which is indeed present in the data as we will later show.We also use a new REER dataset that covers a larger numbers of countries over an extended period of time, allowing to observe changes of the REER subject to different economic conditions.