In this note we show that the real exchange rate was indeed weakly exogenous in some of the specifications in MacDonald and Ricci (2004), but argue this was in all likelihood a function of the relatively limited degrees of freedom. We demonstrate here that by increasing the degrees of freedom, we can satisfy the weak exogeneity condition, whilst at the same time producing equilibrium estimates of the Rand which are quantitatively and qualitatively the same as those reported in MacDonald and Ricci (2004). MacDonald and Ricci (2004) [MR] use a behavioural equilibrium exchange rate approach to provide estimates of the equilibrium real exchange rate of the South African Rand. Our approach aimed at achieving a balance between theoretical correctness and econometric consistency. The bottom line of MR's analyses is that the Rand was substantially undervalued in early 2002. In his comment on our paper, Professor Stan du Plessis argues that because the real exchange rate in our preferred specification was weakly exogenous, this means that our model 'does not qualify as a model for the real effective exchange rate of the Rand'. In our response we discuss why our exchange rate model is a suitable vehicle for making inferences about the extent to which the Rand is misaligned. In this note we show that although the real exchange rate was indeed weakly exogenous for the preferred specification in MR, this was in all likelihood a function of the relatively small sample period available. Increasing the degrees of freedom, we can satisfy the weak exogeneity condition, whilst at the same time producing equilibrium estimates of the Rand which are quantitatively and qualitatively the same as that reported in MR. On this basis, therefore, we argue that we have indeed produced a model of the real effective exchange rate for the Rand which allows us to draw inferences about the extent of over or undervaluation of the Rand, which was the starting point of our original exercise, and which will, we believe, be useful for practitioners and policy makers.
