Abstract

This paper has surveyed the main methods being employed both inside and outside the IMF to assess the consistency of exchange rates with economic fundamentals. The focus of Section II was on one of the key variables often used in evaluating a country’s current exchange rate, namely, its international competitive position. Such an evaluation typically entails a comparison of past movements in prices or costs at home and abroad with nominal exchange rates. If such a comparison reveals a substantial gain or loss in competitiveness relative to a base period in which a country’s external position was regarded as in equilibrium, there is a presumption that the current exchange rate is out of line with the equilibrium exchange rate. Study of earlier periods of external disequilibria and of exchange market pressure suggests that large changes in competitiveness were often an important factor in the generation of such pressure, thereby lending some support to this presumption.

This paper has surveyed the main methods being employed both inside and outside the IMF to assess the consistency of exchange rates with economic fundamentals. The focus of Section II was on one of the key variables often used in evaluating a country’s current exchange rate, namely, its international competitive position. Such an evaluation typically entails a comparison of past movements in prices or costs at home and abroad with nominal exchange rates. If such a comparison reveals a substantial gain or loss in competitiveness relative to a base period in which a country’s external position was regarded as in equilibrium, there is a presumption that the current exchange rate is out of line with the equilibrium exchange rate. Study of earlier periods of external disequilibria and of exchange market pressure suggests that large changes in competitiveness were often an important factor in the generation of such pressure, thereby lending some support to this presumption.

Each of the available measures of international competitiveness carries its own strengths and weaknesses. Much of the time these different indicators of competitiveness will behave in a similar fashion, especially during periods of large swings in nominal exchange rates. That being said, the tendency of these different indicators to capture different aspects of competitiveness, as well as differences in data availability, timing, and coverage, usually makes it desirable to examine them as a group to determine whether they are sending a robust signal. In a similar vein, selection of an appropriate base period (when the external position was regarded as in equilibrium) requires some weighing of alternatives, particularly since what is a good base period for the home country may not be a good base period for the partner countries included in the comparison.

The biggest problem, though, with the competitiveness approach (that is, with purchasing power parity calculations) is its assumption of an unchanging equilibrium real exchange rate. This rate is in fact affected by a host of considerations—ranging from permanent changes in the terms of trade to alterations in saving and investment propensities. Other factors also contribute to significant deviations from purchasing power parity, especially over the short to medium term. In the end, therefore, competitiveness and purchasing power parity considerations are best viewed as important but not the sole components of any serious assessment of exchange rates.

To get around many of the shortcomings of the competitiveness model, a more comprehensive, “macroeconomic” approach is needed. Section III of the paper described the basic elements of such a macroeconomic approach. This approach attempts to abstract from cyclical and other short-term influences on the current account by focusing on positions of internal and external balance over the medium term. Internal balance is defined as a level of output close to potential with a low, sustainable rate of inflation. External balance is best interpreted as a current account position that reflects equilibrium levels of national saving and investment under conditions of internal balance. Shifts in fundamental economic conditions—for instance, the discovery of oil, sustained intercountry differences in labor productivity, or changes in the age distribution of the population—are permitted under this approach to alter the underlying external balance and the equilibrium exchange rate as well. Suffice it to say that, given the present state of the art, figuring out by how much changes in fundamental economic conditions will alter the underlying current account—country by country—remains a difficult task. The fairly wide variation in existing estimates of price and income elasticities for traded goods injects an additional source of uncertainty into the calculations of the required (endogenous) change in the exchange rate and the needed (exogenous) changes in its determinants that will deliver the desired current account position.

Nonetheless, the macroeconomic balance approach represents a significant improvement over the narrower competitiveness approach. Although it cannot be expected to generate a precise estimate of the “right” or “equilibrium” exchange rate, it yields a useful framework for making informed inferences about large present or prospective exchange rate misalignments. Still, a considerable degree of judgment is necessary to interpret the exchange rates that are derived from the macro-economic balance approach as being “consistent with economic fundamentals” for several reasons. For one thing, exchange rates are driven by financial market conditions as well as by real underlying economic fundamentals. For another, one cannot be very precise in identifying positions of external and internal balance. And finally, the role of the exchange rate in overall economic policy differs under fixed and floating rate regimes (a nominal anchor role versus a shock absorber or external adjustment role). Given the uncertainties and sources of error inevitably associated with calculating equilibrium or fundamental real exchange rates, it is clearly more realistic to think of ranges rather than of point estimates in the assessment of exchange rates.

This does not mean that the potential contribution of the macroeconomic balance approach is minimal. Identifying and correcting relatively large misalignments at an early stage would be helpful. In this regard, the costs of a misaligned exchange rate—especially when it involves a major currency—may increase more than proportionally with the size of the misalignment. It is also likely that as work continues on the methodology, it may well be possible to narrow the confidence bands surrounding the estimates. Moreover, the present methodology has to be compared with the alternatives: few would argue that the market exchange rate is always the right rate, especially in view of the past decade’s experience; the performance of shorthand indicators (interest rate differentials, exchange market intervention, and so forth) as predictors of exchange market pressures has been less than impressive, and back-of-the-envelope estimates of equilibrium exchange rates are typically subject to more extreme assumptions and longer leaps of faith than those associated with the approach discussed here.

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