Abstract

For at least three decades, the staff of the International Monetary Fund has been engaged in efforts to develop and sharpen “tools to enable it to get a clearer view of what exchange rates were or were not reasonably close to equilibrium levels…”1 Such analysis has been viewed as an integral part of the Fund’s responsibility for exercising “firm surveillance over the exchange rate policies of members….”2

For at least three decades, the staff of the International Monetary Fund has been engaged in efforts to develop and sharpen “tools to enable it to get a clearer view of what exchange rates were or were not reasonably close to equilibrium levels…”1 Such analysis has been viewed as an integral part of the Fund’s responsibility for exercising “firm surveillance over the exchange rate policies of members….”2

To a large extent, the IMF’s internal analysis of exchange rate issues has been guided by, and limited by, the conceptual and empirical frameworks that have emerged from the collective research of the economics profession. The research has provided several general approaches that are useful for assessing whether countries’ exchange rates seem broadly appropriate. One involves the calculation of purchasing-power-parity (PPP) measures or international competitiveness indicators. A second, known as the macroeconomic balance framework, focuses on the extent to which prevailing exchange rates and policies are consistent with simultaneous internal and external equilibrium over the medium run.

Some recent extensions of the macroeconomic balance approach and the manner in which it is applied by the IMF staff are described in this Occasional Paper.3 Section II provides a general description of the analytic framework and the different steps in the assessment process, including discussions of the limitations of the methodology and the role of judgment. Section III focuses on assessments of exchange rates among the currencies of the major industrial countries during recent years and discusses the extent to which the Fund’s judgments were guided by the macroeconomic balance framework. Sections IVVII present specific descriptions of various aspects of the analytic framework. Section VIII describes a dynamic application of the macroeconomic balance approach, using the Japan block of MULTIMOD—the Fund’s multiregional econometric model.

Operational work and research on exchange rate issues are ongoing at the IMF. Attention continues to be directed at improving and extending the applicability of the methodology discussed here, as well as developing and applying other analytic frameworks. In this regard, it may be noted that recent applications of the macroeconomic balance approach within the IMF have focused primarily on industrial countries,4 while for most developing and transition economies, the IMF staff has tended to rely on other analytic frameworks in its continuing work on exchange rate issues.

As summarized in Box 1.1, there are alternative views about the usefulness of calculating “equilibrium” exchange rates. Moreover, those who engage in such calculations have come to recognize that deviations from equilibrium exchange rates can reflect several different factors and need to be interpreted carefully.

Some economists, both among the IMF staff and within the economics profession more generally, question whether exchange rates can ever become substantially misaligned with economic fundamentals. While it is recognized that macroeconomic policies may sometimes become unsustainable or otherwise undesirable, and that unsound macroeconomic policies can drive exchange rates to undesirable levels, this does not necessarily imply, as a logical proposition, that market exchange rates ever become strongly inconsistent with fundamentals when economic policies are taken into account. A second group accepts the position that exchange rates can become substantially misaligned in principle but questions whether any particular econometric model, or set of models, can adequately quantify such misalignments in practice.

Alternative Views on Evaluating Exchange Rates

There are alternative views on the usefulness of calculating equilibrium exchange rates and evaluating whether currency values may have become “misaligned.” One view is that exchange rates, in their role of clearing foreign exchange markets, always reflect economic fundamentals; accordingly, although exchange rates can deviate in the short run from their medium-run or long-run equilibrium levels, they are always appropriate reflections of existing and projected macroeconomic outlooks and policies. A second view accepts the concept of exchange rate misalignment while remaining skeptical about the ability of any particular model, or set of models, to adequately quantify misalignments in practice.

A third view maintains that quantitative assessments of exchange rates are useful, while also emphasizing that deviations of exchange rates from medium-run equilibrium levels are not always a source of concern. According to this view, the key question is the appropriateness of economic policies: an apparent “misalignment” can be either consistent or inconsistent with prevailing policies and does not say anything about whether the policies are desirable.

To illustrate the latter point, consider a situation in which country A’s real effective exchange rate is substantially depreciated relative to an estimate of its medium-run equilibrium level. Possible interpretations include:

  • The prevailing exchange rate is appropriate, even though it differs from its medium-run equilibrium level. This might be the case, for example, if economic activity in country A is weak, with the depreciated exchange rate providing helpful stimulus, and if interest rates in country A are relatively low as a reflection of countercyclical monetary policy. In such a situation, international interest rate differentials might be interpreted as suggesting that country A’s currency is expected to appreciate over time toward the level consistent with medium-run fundamentals.

  • The prevailing exchange rate is appropriate given policies, but policies are inappropriate. This might be the most relevant interpretation for cases in which fiscal deficits are excessive. Support for this interpretation would be strengthened if international interest rate differentials are also large, and if market commentary suggests that the interest differentials can be interpreted as reflecting concerns about fiscal deficits.

  • The prevailing exchange rate is inappropriate given policies, but policy adjustment would be appropriate. This might be the most relevant interpretation if economic activity in country A is relatively strong, with the depreciated exchange rate providing unhelpful stimulus, and if overheating concerns provide a case for raising interest rates, which not only would cool the economy but also would tend to appreciate the exchange rate.

  • The prevailing exchange rate is inappropriate given policies, and policy adjustment would be inappropriate. Such circumstances raise the question of whether policy authorities should make an effort to influence market perceptions.

A third view maintains that some market exchange rates have at times become badly misaligned with fundamentals and that a quantitative framework is important for trying to identify misalignments at an early stage. This view has motivated recent efforts within the IMF to strengthen the macroeconomic balance framework, as described in this study. That being said, the analytic framework presented here should be seen as simply a starting point that provides systematic, globally consistent, and transparent initial assessments of exchange rates. The initial assessments need to be reevaluated, and sometimes modified, by bringing other information and judgments to bear. In this way, the quantitative assessments derived from the macroeconomic balance framework complement, rather than substitute for, the various measures of international competitiveness and financial market conditions that have traditionally played a major role in the IMF’s surveillance over members’ exchange rates and exchange rate policies.

The framework described cannot deliver precise estimates of equilibrium exchange rates. Indeed, for market-determined exchange rates, the notion that precise values for equilibrium exchange rates exist is probably bogus. Accordingly, the IMF’s assessment process is designed to be consistent with the view that considerable deference should be given to markets before suggesting that exchange rates are misaligned. The objective of the process is to estimate “reasonable ranges” for real exchange rates from a medium-run perspective and to identify circumstances in which market-determined exchange rates have moved outside these “reasonable ranges.”5

In addition to recognizing that estimates of equilibrium exchange rates are inherently imprecise, the IMF’s analysis acknowledges that situations in which prevailing exchange rates deviate substantially from their medium-run equilibrium values do not always imply that “markets are wrong.” In some cases, particularly when countries are in different phases of the business cycle, market participants may expect exchange rates to move over time toward their medium-run equilibrium levels, such that the initial deviations from medium-run equilibrium rates would be largely eliminated. These anticipated adjustments of exchange rates—from appropriate levels in the short run to equilibrium levels in the medium run—would normally be reflected in the interest rate differentials (and forward exchange rates) associated with appropriate countercyclical monetary policies. In other cases, substantial deviations of exchange rates from their medium-run equilibrium levels may imply that “policies are wrong.” Such situations are also sometimes characterized by large interest rate differentials—for example, when they reflect market concerns about large fiscal imbalances—but do not necessarily imply that markets are wrong, given such policy concerns. In still other cases, however, substantial deviations from mediumrun equilibrium exchange rates may be identified against a background of sound policies and relatively narrow interest differentials, suggesting that currencies may indeed have become misaligned.

There is no general answer to the question of what actions, if any, should be taken when exchange rates appear to deviate substantially from their medium-run equilibrium values. Rather, the question is appropriately addressed on a case-by-case basis in the context of a broader assessment of the macroeconomic situation. Policy advice in such circumstances should be conditioned primarily by the extent to which macroeconomic policies seem consistent with ultimate targets, and much less so by the extent to which market exchange rates deviate from estimates of their equilibrium levels.

1

Jacques J. Polak, 1995, “Fifty Years of Exchange Rate Research and Policy at the International Monetary Fund,” Staff Papers, International Monetary Fund, Vol. 42, pp. 734–61, at p. 740.

2

International Monetary Fund, Articles of Agreement, Article IV, Section 3(b).

3

See Peter B. Clark, Leonardo Bartolini, Tamim Bayoumi, and Steven Symansky, Exchange Rates and Economic Fundamentals: A Framework for Analysis, IMF Occasional Paper No. 115 (Washington: International Monetary Fund, 1994) and Jacques R. Artus, and Malcolm D. Knight, Issues in the Assessment of Exchange Rates of the Industrial Countries, IMF Occasional Paper No. 29 (Washington: International Monetary Fund, 1984) for previous IMF perspectives on methodologies for exchange rate assessment.

4

Because the macroeconomic balance approach implicitly assumes that countries have unrestricted and uninterrupted access to international capital markets, substantial modifications of the methodology are required before it can be applied to developing and transition economies. Applications to the latter groups of economies are also constrained by data limitations.

5

Such reasonable ranges must not be confused with the concept of “target zones.” Specification of target zones for major currency exchange rates implies a serious commitment to adjust economic policies to hold exchange rates within these zones. Outside of Europe, no such policy commitment for the major industrial countries exists.

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