Abstract

How to assess the misalignments of real exchange rate in developing countries has been a difficult and unresolved issue. Over the decades, researchers have not found desirable methods to estimate the “Equilibrium Exchange Rate”. The Purchasing Power Parity (PPP) approach has limitations, and the fixed or managed floating exchange rate regimes in developing countries make the estimating more difficult. The purpose of this paper is to discuss the limitations of the Macroeconomic Balance approach and the existing PPP approach for estimating equilibrium exchange rate in developing countries, and introduce a new method–the Adjusted PPP method to assess exchange rate in developing countries. The new method includes the Human Development Index (HDI) to adjust the traditional PPP estimates. By introducing the adjustments of HDI, the big quality differences in non-tradable goods and services between developed and developing countries are adjusted for the exchange rate estimates. Also, as a case study, the paper estimated the exchange rate in China of 1991-2013.

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