Abstract

Article IV of the International Monetary Fund’s Articles of Agreement stipulates, among other things, that the Fund “shall exercise firm surveillance over the exchange rate policies of members.” An integral part of that mandate is the close monitoring and careful evaluation by the IMF of exchange rates and of their underlying determinants—no matter what the member’s chosen exchange rate arrangements. The substantial overvaluation of the U.S. dollar in 1984–85, the turbulence and sudden adjustments of parities and margins within the European Monetary System in 1992–93, and the large realignment of the CFA franc in early 1994 all bear eloquent testimony to the proposition that exchange rates can get out of line with economic fundamentals. One aim of IMF surveillance activities, such as Article IV consultations and the World Economic Outlook, is to decrease the frequency and size of such exchange rate “misalignments” by encouraging a more timely adjustment of macroeconomic policies and/or exchange rates themselves.

Article IV of the International Monetary Fund’s Articles of Agreement stipulates, among other things, that the Fund “shall exercise firm surveillance over the exchange rate policies of members.” An integral part of that mandate is the close monitoring and careful evaluation by the IMF of exchange rates and of their underlying determinants—no matter what the member’s chosen exchange rate arrangements. The substantial overvaluation of the U.S. dollar in 1984–85, the turbulence and sudden adjustments of parities and margins within the European Monetary System in 1992–93, and the large realignment of the CFA franc in early 1994 all bear eloquent testimony to the proposition that exchange rates can get out of line with economic fundamentals. One aim of IMF surveillance activities, such as Article IV consultations and the World Economic Outlook, is to decrease the frequency and size of such exchange rate “misalignments” by encouraging a more timely adjustment of macroeconomic policies and/or exchange rates themselves.

This paper summarizes the methods and types of indicators that are often employed, both inside and outside the IMF, to assess whether exchange rates are broadly in line with economic fundamentals. Much of the present conceptual framework represents refinements and extensions of earlier contributions to the analysis and surveillance of exchange rate policies,1 Several considerations in applying this framework to the assessment of exchange rates warrant explicit mention at the outset.

As far back as 1945, Nurkse defined the equilibrium exchange rate as the rate that would yield equilibrium in the balance of payments, but with three important qualifications: that there be (i) no undue restrictions on trade flows, (ii) no special incentives for inflows or outflows of capital, and (iii) no excessive unemployment.2 In other words, the equilibrium in the balance of payments should reflect appropriate policies and underlying economic conditions, and should not be achieved by policy distortions or unsustainable rates of resource utilization; by implication, a balance of payments position associated with chronic excess demand and high rates of inflation would also be regarded as an inappropriate external position.3 In this framework, therefore, the balance of payments is the key “economic fundamental” determining equilibrium exchange rates—but only after that balance of payments position has been adjusted for temporary influences, for special factors, and for movements in other key economic variables closer to their longer-term values. This distinction between observed outcomes and the “underlying” equilibrium, and the relationship between this underlying equilibrium and the fundamentals, are at the heart of most equilibrium exchange rate exercises.

A second key issue that arises in any effort to evaluate the consistency of exchange rates with economic fundamentals is the time dimension over which exchange rates and their determinants are to be assessed. The time horizon is important for two reasons. To begin with, those factors that have the most influence on exchange rates over the short term are not necessarily the same ones that will exercise the most influence over the long term. For example, if the relevant time horizon is two months, changes in the near-term stance of monetary policy and the resultant behavior of short-term interest rates might well be the main driving forces on exchange rates. By contrast, if the relevant period is the long term, say, a decade, greater attention would need to be paid to such factors as underlying saving and investment propensities, which are affected by such slow-moving forces as changes in demographics and technology. Alternative methods of assessing the consistency of exchange rates with economic fundamentals often employ different time horizons and therefore implicitly select different sets of economic fundamentals.

This paper focuses on the medium to long term and therefore abstracts from cyclical and short-term influences on the exchange rate. Consequently, a rate’s current value will often depart from the level that would be consistent with underlying determinants from a longer-term perspective. While the actual exchange rate may be out of line with an exchange rate consistent with medium-term fundamentals, this should not be construed as implying that it is necessarily inconsistent with short-term determinants, for example, interest rate differentials, which are among the relevant fundamentals at the short end of the time dimension.

Another relevant consideration in the time dimension of assessing exchange rates is the distinction between backward- and forward-looking approaches. A backward-looking approach generates an estimate of the current equilibrium rate by searching for a period of equilibrium in the past and then updating that rate for the changes that have taken place between the base period and the present. A forward-looking approach bases the estimate on the rate that would produce an equilibrium position in the future, given our best guess as to what will happen to the fundamentals over the medium term. Models that view exchange rates as asset prices imply that they are inherently forward-looking variables. This in turn implies that the current value of the exchange rate reflects expectations of the future evolution of the fundamentals, and that exchange rates will change when there are changes in expectations about the future path of these fundamentals (that is, when there is “news”). In Sections II and III below, both backward- and forward-looking approaches are examined.

A third dimension of the analysis is the extent to which it is multilateral, namely, which foreign variables should be included in the list of economic fundamentals. Analyzing equilibrium exchange rates necessarily involves the use of effective exchange rates, that is, of weighted averages of bilateral exchange rates rather than of individual bilateral rates. The need to account for the effects of a wide array of foreign variables puts a premium on methods that highlight interactions of the fundamentals between a country and many of its trading partners. This consideration encouraged the development of some of the early multilateral exchange rate models and has continued to generate considerable demand for later-generation, multicountry macroeconomic models (such as the IMF’s MULTIMOD). The continuing relevance of multilateral interactions is well illustrated by the dynamic, sequential nature of exchange rate pressures in the exchange rate mechanism (ERM) of the European Monetary System (EMS) during the fall of 1992. The currencies that first came under pressure and were devalued altered somewhat the “fundamentals” (for example, the competitive position) of currencies that had not been attacked, and presumably these changes affected in part the exchange rate pressures that the latter subsequently faced. The wider and stronger are such interdependencies, the more important it is to adopt a multicountry approach to the analysis of the fundamentals.

A fourth key point underlying the analysis is that because the primary concern is with real exchange rates—that is, nominal exchange rates adjusted for price level differences between countries—the methodological issues explored in this paper are as relevant for countries that adopt policies of freely floating exchange rates as they are for countries that target nominal exchange rates at a particular level or within a particular band. Nonetheless, some differences in the assessment of real exchange rates do arise between floating and pegged exchange rate systems. On the one hand, under floating rate systems fluctuations in nominal exchange rates represent an important source of real exchange rate variability—in addition to movements of domestic prices—that is absent from pegged exchange rate systems. On the other hand, continuous movements in nominal exchange rates give floating rate systems an additional channel for real exchange rate adjustments unavailable in pegged rate systems (barring recourse to periodic, sometimes traumatic, discrete adjustments in parities). Thus, significant real exchange rate fluctuations are more likely to arise in a floating rate system, but the flexibility of the nominal rate is also an important mechanism for macro-economic adjustment.

By contrast, when the nominal exchange rate is maintained within a narrow band, movements in real exchange rates tend to be more moderate. However, if the real exchange rate gets out of line with fundamentals, an explicit decision must be made either to change the nominal exchange rate or to bring the underlying fundamentals in line with the existing nominal exchange rate through other policies or mechanisms. For instance, if it is desired to maintain a pegged nominal rate that has become inconsistent with, say, international competitiveness considerations, adjustments must be made in other areas of the economy, such as domestic prices and wages, in order to achieve a real exchange rate consistent with an equilibrium position.

Several restrictions have been placed on the scope of this paper to keep it within manageable proportions. First, no attempt has been made to assess the overall functioning of the international monetary system, to provide a comprehensive survey of the IMF’s surveillance over exchange rate policies, or to analyze the policy issues that arise when exchange rates are out of line with economic fundamentals.4 These subjects have been treated in other papers.5 Instead, the aim is simply to give an up-to-date summary of some of the analytical tools for assessing the consistency of exchange rates with economic fundamentals. Second, the paper focuses on the exchange rates of industrial countries. This is not because the assessment of exchange rate policies in developing countries is any less important or less amenable to traditional methods of exchange rate analysis. Rather, this focus reflects the view that structural differences between industrial and developing countries (including the degree of diversification in the range of goods and services produced, susceptibility to terms of trade shocks, degree of capital mobility, and trend rates of inflation) and differences in the models currently available for assessing country interactions make it preferable to treat the two groups separately. To some extent the analysis of exchange rate issues relating to developing countries has already been done in earlier work, particularly Aghevli, Khan, and Montiel (1991).

The rest of the paper proceeds as follows. Section II discusses the assessment of exchange rates based on measures of international competitiveness. Such an assessment involves comparing past movements in prices or costs at home and abroad, taking into account changes in nominal exchange rates; the focus is thus on developments in a country’s real exchange rate. If such an examination reveals a substantial gain or loss in competitiveness relative to a base period in which the external position was regarded as in equilibrium, there is a presumption that the exchange rate is no longer consistent with the underlying external position of the country. While a country’s international competitive position is clearly one important determinant of its current account, since it is a key relative price determining the choice between domestic and foreign goods and services, other factors are also relevant. More specifically, this approach assumes an unchanged equilibrium real exchange rate and ignores future developments that affect the rate, and thus it provides only a partial and incomplete analysis. A full assessment of exchange rates, therefore, requires a more general framework suitable for the analysis of the determinants of equilibrium real exchange rates.

Such a framework is provided in Section III. It is based on a macroeconomic approach of internal and external balance that abstracts from short-term, cyclical fluctuations in output, inflation, and interest rates and focuses on exchange rates that are consistent with economic fundamentals over the medium term. By “internal balance” we mean a situation in which real output is at its potential level and inflation is at a low and nonaccelerating rate. By “external balance” we mean a current account position that would be generated by the economic fundamentals of national saving and investment when the economy is in internal balance, with the additional requirement that the resulting path of net foreign assets must be sustainable. An integral part of the notion of macro-economic balance as used in this paper is that the appropriate monetary and fiscal policies are being followed over the medium term. The calculation of real exchange rates consistent with internal and external balance provides a framework for assessing the consistency of the actual exchange rate with economic fundamentals, which are those key variables underlying the macroeconomic balance position. Illustrative calculations from the existing literature on this topic are discussed; this discussion highlights the important point that while this approach can yield estimates of equilibrium exchange rates, such estimates are subject to a considerable margin of uncertainty. As such, it is possible to generate only a broad range of equilibrium exchange rates to serve as a benchmark for judging whether a country’s present exchange rate is consistent with economic fundamentals.

Section IV offers some concluding remarks. It is argued that while each of the methods of assessing the consistency of exchange rates with economic fundamentals has certain drawbacks that preclude precise estimation of the “right” exchange rate, those methods—when applied in concert—can nonetheless be useful in identifying exchange rates that are relatively far divorced from economic fundamentals, as well as in raising questions about the sustainability of exchange rates that are less obvious outliers.

1

In this sense, the present paper might be considered an update of the 1984 IMF Occasional Paper Issues in the Assessment of the Exchange Rates of Industrial Countries (IMF, 1984).

2

See his Princeton Essay published in 1945 entitled “Conditions of International Monetary Equilibrium” (Nurkse (1945) reprinted in Kenen (1993)).

3

The principles of IMF surveillance over exchange rate policies mention the types of distortions and policies that are inconsistent with balance of payments equilibrium.

4

Similarly, this paper does not analyze in any detail the possible specific causes of a departure of the exchange rate from the level suggested by economic fundamentals. Such an analysis would obviously be an integral part of a discussion of the relevant policy issues.

5

See Crockett and Goldstein (1987); Frenkel, Goldstein, and Masson (1991); Goldstein and others (1992); World Economic Outlook: Interim Assessment (IMF, 1993a); and International Capital Markets, Pt. 1, Exchange Rate Management and International Capital Flows (IMF, 1993b).

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