Measuring exchange rate misalignment: Inflation differentials and domestic relative prices

Empirical studies of exchange rate misalignment generally use crosscountry differences in overall inflation as proxy measures for a country's real exchange rate (RER). This paper shows that using such differential-inflation proxies introduces two systematic biases in model results: understatement of RER movements; and a spurious trend towards depreciation. These biases can be corrected only with disaggregated data on domestic relative prices of tradable and nontradable products. Using a standard model with disaggregated data for Zimbabwe, it is found that proxy-based results understate misalignment by almost 25% and exaggerate depreciation by 4% per year. (C) 1998 Elsevier Science Ltd. All rights reserved.