At various places throughout this book we have discussed the role of the real exchange rate as a key macroeconomic relative price. As the relative price of foreign goods (goods produced abroad) in terms of domestic goods (goods produced at home), the real exchange rate plays an important role in guiding the broad allocation of production and spending in the domestic economy between these two types of goods. Because of this important allocative role of the real exchange rate, emerging economies are often encouraged to conduct their affairs so as to get this particular macroeconomic relative price “right” – that is, to make sure that the economy's actual real exchange rate does not stray too far from its equilibrium value, a situation that is known as exchange rate misalignment.

Why is the avoidance of misalignment so important? As we will discuss more fully in this chapter, there are two key reasons: when the exchange rate is misaligned, it will not provide the appropriate signal to guide the allocation of resources between domestic and foreign goods. In addition, as mentioned in the last chapter, when the real exchange rate is perceived to have become severely misaligned, the expectation will be created that it will adjust toward its equilibrium value in the future. To the extent that this adjustment is expected to take place through movements in nominal exchange rates, this will discourage domestic agents from holding assets denominated in domestic currency, which is a potential source of capital-flow reversals and exchange rate crises.