Jacques R. Artus
Most major industrial countries have in recent years opted for a managed floating exchange rate regime where the authorities take a position with respect to the level of their exchange rates whenever they deem it necessary. If the intervention of the authorities is to be stabilizing rather than destabilizing, however, it is crucial that the explicit or implicit exchange rate target—or, at least, the notion of an “acceptable” zone—should be identifiable with the longer-run equilibrium rate, that is, the value toward which the actual exchange rate would normally tend to move in the longer run, given existing policies. This summary examines three different methods that the national authorities may want to use to assess deviations between the current exchange rate and the longer-run equilibrium rate, the S* rate.
Why do national authorities worry about large fluctuations in their exchange rates? A few years ago, the main reason was that exchange rate instability would discourage foreign transactions. Now, attention is focused more on the frictional social costs of instability (such as temporary unemployment in certain sectors) and, even more, on its relationship to inflation.
On the other hand, it has become evident over the past four years that an active rate management policy does not necessarily ensure exchange rate stability. During that period, many countries have ultimately had to accept large and perhaps excessive changes in their rates under chaotic conditions, after having engaged in massive intervention in defense of a particular rate. With this background in mind we can now examine the three commonly used methods of determining longer-run equilibrium in an exchange rate.
A more detailed discussion of this topic is available in an article by the same author in a forthcoming issue of the Journal of International Economics.
Purchasing power parity
The S* rate may be defined as the expected purchasing power parity (PPP) between the currency of the country considered and the currencies of the rest of the world, one to two years ahead. The PPP method assumes that a projection of available price series can in practice be used to calculate a ratio of the country’s domestic price level to the average price level of its trading partners that provides a reasonable estimate of the (average) purchasing power parity value of its currency in terms of foreign currencies. If all countries produced exactly the same goods, all goods were tradable, and there was no impediment to free trade, the PPP method would be a strict application of the law of one price. The PPP value of a currency could easily be measured, and exchange rate deviations from that measured value could only reflect a slow working of the arbitrage process in the goods markets. Such conditions are never satisfied.
PPP proponents, however, claim that deviations from these ideal conditions are not so great as to invalidate the PPP approach; they assert that it is possible to find price data which can be used to measure the PPP value of a currency and to get a fair estimate of the S* rate. Data on absolute price levels are difficult to find. In most cases the PPP theory is used in its relative form, with the S* rate defined as the product of the exchange rate in a base period, when the actual rate is equal to the S* rate, and the ratio of the countries’ price indices.
There are three major problems that are encountered in applying the relative PPP method to estimate divergences between the actual exchange rate and the S* rate, namely: (1) the choice of a base period; (2) the choice of the relevant price indices; and (3) the projection of the price indices one or two years ahead. The first two problems are particularly intractable.
The choice of a base period assumes that one already knows how to recognize whether an actual rate diverges from the S* rate. Strictly speaking, the relative PPP method can thus be applied only when it is no longer needed. At a less rigorous level, it is assumed that one can identify a situation in which the actual rate is probably not far from the S* rate, for example by looking at the current balance position. The risks of errors in such a subjective judgment are extremely large, however.
Available price indices are also not really suitable for PPP calculations. The gross domestic product (GDP) deflator places a heavy weight on nontradable goods which are not directly relevant. Prices of traded goods may be set in the short run to maintain competitiveness in world markets regardless of the overall domestic price and cost levels so that they can also be a biased indicator of the S* rate. Further, the various countries produce the various kinds of tradable goods in different proportions. This gives rise to an insoluble index number problem.
A further weakness of the PPP method is that it makes no allowance for changes in price competitiveness that are needed to offset developments relating to capital flows or to the price of an imported product which has no domestic substitutes.
The PPP method is not difficult to apply, but neither is it reliable—except under certain restricted conditions, namely, when the source of the relative price change is a disturbance that affects most prices roughly equally and within a short period of time. This will tend to occur in the case of a monetary shock or a sudden change in the money wage rate.
Ultimately, there is a need to confront the information provided by the PPP indicators with an assessment of the evolution of the balance of payments of the country concerned. For example, it would be silly to argue that a country’s exchange rate is appropriate on the basis of PPP indicators when it is experiencing a marked and persistent worsening of its trade performance that cannot be explained by cyclical or other temporary factors.
Underlying payments disequilibria
The underlying payments disequilibria (UPD) method focuses on the underlying balance of payments position of a country rather than on the level of its prices. The difference between the actual rate and the S* rate is inferred from an estimate of the difference between the underlying balance of payments position corresponding to the price level expected one or two years ahead, and what can be considered a desired and sustainable balance of payments position.
The UPD method includes four steps. The first of these is the calculation of the most recent current account position, adjusted for temporary disturbances—principally, the effects of cyclical variations in output and employment from their medium-term norms. Allowance must also be made for other disturbances affecting the current balance in a temporary manner. In practice, however, only the effects of major disturbances can be quantified, such as the effects of crop failures or major strikes.
The second step in calculating the underlying balance of payments position is to project the current account position adjusted for temporary disturbances. Current trade flows reflect past prices because of the long lags often observed in the effects of relative price changes on trade flows. In a UPD exercise it is necessary to assess what would be the current account position corresponding to the relative domestic price levels projected one or two years ahead (on the assumption of an unchanged exchange rate) once the trade flows have adjusted to these price levels. In addition, effects of expected changes in the nonprice factors will also have to be taken into account.
Next a calculation should be made of the current account position which corresponds to a desired and sustainable structure of the balance of payments over the medium term. This structure will depend on the “normal” capital flows, which correspond to the primary role of reallocating savings among countries to equalize rates of return on investment. Such flows would reflect the country’s stage of development, its savings preferences, and so on. Large disturbances—such as the exploitation of the North Sea oil field by Norway and the United Kingdom, or of natural gas reserves by the Netherlands—must also be taken into account since they may warrant a sustained change in the balance of payments structure.
Finally, the needed change in the exchange rate should be calculated. The comparison of the underlying current account position with the optimal long-run current account position provides an estimate of the required change in the current account. A model is then needed to calculate the exchange rate change that would bring about the desired current account adjustment.
The UPD method is much more sophisticated than the PPP method, but there are numerous technical difficulties with it. The implementation of the UPD method requires a fairly complete world trade model which traces the effects of relative price changes and various temporary factors on foreign trade flows (see “The World Trade Model: Merchandise Trade,” by Michael C. Deppler and Duncan M. Ripley, in the March 1978 issue of the International Monetary Fund’s Staff Papers). An “operational” method of calculating optimal long-run current account (capital account) positions is also needed.
The significant advantage of the UPD method over the PPP method is that it does not depend on some observable relative price index as the major, if not the exclusive, determinant of the long-run trade performances of a country. In fact, in implementing the UPD approach, it soon becomes obvious that the movements of available relative price indicators are remarkably poor measures of relative trade performance. This, of course, does not mean that prices do not matter; it is, however, an indication of how unreliable existing relative price indicators are. By focusing on the present balance of payments position of a country, the UPD method encompasses all of the factors that may influence the foreign exchange transactions of a country rather than only the price factors. Further, it does not require so precise an estimate of past changes in relative prices as the PPP method, unless the changes in relative prices are recent and have not yet been translated into trade effects.
Asset market disturbances
The two previous methods focus on the long-term determinants of the exchange rate. An alternative method suggested here for countries relying heavily on market forces is to study the short-run determinants of the exchange rate, and then to adjust the actual rate for effects of temporary factors so as to get an estimate of the long-run equilibrium rate. This latter method has not yet been fully explored empirically. It should, however, be possible to develop this approach on the basis of the asset-market theory of exchange rate determination.
The asset-market theory focuses on the equilibrating role of the exchange rate in balancing the foreign demand for domestically issued financial assets and the domestic demand for foreign financial assets. (See Finance & Development, December 1977, for a discussion by J. Artus and A. Crockett on the asset-market theory of exchange rate determination in their article “Floating exchange rates—some policy issues.”) Various models have been presented in the literature using this theory to show how various monetary and real shocks can lead to sustained divergences between the current exchange rate and the S* rate. Such models could be used to calculate the divergence that is likely to have been the result of certain policy measures or certain temporary current payments imbalances.
The asset-market disturbances (AMD) method is more complex than the PPP method, but simpler than the UPD method. It can be applied without substantial model building, and, yet, is not as simplistic as the PPP method. It has, however, an obvious weakness: it assumes that one can identify relatively well the factors behind exchange rate expectations. These factors can certainly be identified as far as market participants are rational. To the extent that they are not, however, it becomes difficult to “explain” the current exchange rate, and the method loses much of its operational usefulness.
Another weakness of the method is that it is applicable only to those few countries that have largely let their exchange rates be determined by the free play of market forces. Few attempts, moreover, have been made to apply it so far, and many difficulties are likely to emerge as it is applied. Nevertheless, this is the only method that attempts to use the experience of market forces, and it would seem useful to try to apply it to countries that rely heavily but not exclusively on the market.
Not a return to parities
The concept of establishing a long-run equilibrium rate is often misunderstood or misinterpreted by policymakers and free-market economists alike as a disguised attempt to re-establish some kind of par value system. It is, therefore, important to note that it reflects the monetary and fiscal policies chosen by the authorities and various anticipated future economic developments such as, for example, the coming-on-stream of North Sea oil in the case of Norway and the United Kingdom. Policies do change, sometimes abruptly, and expectations of future economic developments often have to be revised, so that the long-term equilibrium rate should by no means be assumed to be constant or even subject only to gradual changes. It is more stable than the rate determined by the free play of market forces only because this latter rate is subject to the additional instability arising from short-run variations in the demands for and supplies of the various domestic and foreign financial assets, and cyclical and other temporary variations in the current balance.
The type of exchange rate management considered here aims at reducing the instability arising from short-run asset-market disturbances. This does not mean, however, that the authorities should not in some cases accommodate to some extent such disturbances by accepting a temporary movement in the rate. Further, the forward-looking nature of the long-term equilibrium rate also implies that the authorities should not necessarily attempt to reach it right away. The S* rate is a target which indicates where the rate should be at some time in the future. Various practical considerations have to be weighed by the authorities before deciding whether they should intervene to push the current rate toward the S* rate.
With this background in mind it is apparent that a rough yardstick is needed to help the authorities maintain a reasonable exchange rate, and to prevent it from becoming under- or overvalued by 10, 20, or 30 per cent, as has too often happened in the past. For such purposes, the methods considered here seem adequate, at least if they are interpreted with a clear understanding of the various possible sources of bias. Whenever possible, all three methods should be used, with an attempt made to reconcile their results. In isolation, the PPP method is probably the least reliable of the three methods.