Abstract

This paper has presented three alternative methodologies to help gauge the consistency of current account balances and real effective exchange rates with their underlying fundamentals. While assessments of exchange rate misalignment will always need to be informed by country-specific factors that are difficult to incorporate into studies based on large cross-country data sets, the consistent multilateral approach developed in the foregoing sections should nevertheless prove useful and complementary to the approaches pursued at the IMF country desk level.36

This paper has presented three alternative methodologies to help gauge the consistency of current account balances and real effective exchange rates with their underlying fundamentals. While assessments of exchange rate misalignment will always need to be informed by country-specific factors that are difficult to incorporate into studies based on large cross-country data sets, the consistent multilateral approach developed in the foregoing sections should nevertheless prove useful and complementary to the approaches pursued at the IMF country desk level.36

The three approaches are also intended to be complementary to one another in the process of arriving at “exchange rate assessments.” In many cases the different approaches will yield qualitatively and even quantitatively similar results, but this will not necessarily be the case: the ERER approach focuses directly on prices (exchange rates), while the other two approaches focus on quantities (current accounts and net foreign assets) and then derive the implications for the exchange rate. This difference in focus also implies some differences in the fundamentals being captured under each of the approaches.37 Indeed, the process of arriving at exchange rate assessments is not a mechanical one, in which the results of applying one particular methodology are imposed, or a simple average among all the available approaches is used. For example, a methodology’s estimate for a specific country may be disregarded in light of factors such as data limitations, a short sample, and large sensitivity of that country’s results to minor modifications in the methodology.

The importance of avoiding a mechanical assessment is underscored by the uncertainty surrounding econometric estimates, the inability to fully incorporate all relevant country-specific factors, issues related to data availability and reliability, and potential shifts in the underlying macroeconomic and structural relationships. These problems may be particularly severe for countries undergoing rapid structural change and for those for which sample length is relatively short.

This paper’s other main contribution is to explicitly recognize the much greater weight of key emerging market countries in the problem of global imbalances and currency misalignments. While past exchange rate assessments had an entirely advanced-economy focus, the work developed in this paper is based on a much larger sample of both emerging and advanced economies, and hence is able to capture a much greater share of global trade. This should allow more balanced judgments to be reached on how currencies—of both advanced and emerging economies—ultimately may need to adjust as the currently sizable global current account imbalances are narrowed.

Cited By

  • Ahmed, Shaghil 1986, “Temporary and Permanent Government Spending in an Open Economy: Some Evidence for the United Kingdom,Journal of Monetary Economics, Vol. 17, No. 2, pp. 197224.

    • Search Google Scholar
    • Export Citation
  • Bayoumi, Tamim, Hamid Faruqee, and Jaewoo Lee, 2005, “A Fair Exchange? Theory and Practice of Calculating Equilibrium Exchange Rates,IMF Working Paper 05/229 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Bayoumi, Tamim, Jaewoo Lee, and Sarma Jayanthi, 2006, “New Rates from New Weights,IMF Staff Papers, Vol. 53 (June), pp. 272305.

    • Search Google Scholar
    • Export Citation
  • Bernanke, Ben, and Refet Gurkaynak, 2001, “Is Growth Exogenous? Taking Mankiw, Romer, and Weil Seriously,NBER Macroeconomics Annual (Cambridge, Massachusetts: National Bureau of Economic Research).

    • Search Google Scholar
    • Export Citation
  • Bernheim, B. Douglas, 1987, “Ricardian Equivalence: An Evaluation of Theory and Evidence,” NBER Macroeconomics Annual, Vol. 2, ed. by Fischer Stanley (Cambridge, Massachusetts: National Bureau of Economic Research), pp. 263304.

    • Search Google Scholar
    • Export Citation
  • Blanchard, J. Olivier, Francesco Giavazzi, and Filipa Sa, 2005, “International Investors, the U.S. Current Account, and the Dollar,Brookings Papers on Economic Activity 1, Brookings Institution, pp. 149.

    • Search Google Scholar
    • Export Citation
  • Canzoneri, Matthew B., Robert E. Cumby, and Behzad Diba, 1999, “Relative Labor Productivity and the Real Exchange Rate in the Long Run: Evidence for a Panel of OECD Countries,Journal of International Economics, Vol. 47 (April), pp. 24566.

    • Search Google Scholar
    • Export Citation
  • Cashin, Paul, Luis F. Céspedes, and Ratna Sahay, 2004, “Commodity Currencies and the Real Exchange Rate,Journal of Development Economics, Vol. 75 (October), pp. 23968.

    • Search Google Scholar
    • Export Citation
  • Chen, Yu-Chin, and Kenneth Rogoff, 2003, “Commodity Currencies,Journal of International Economics, Vol. 60 (May), pp. 13360.

  • Chinn, Menzie, 2005, “Getting Serious About the Twin Deficits,Council Special Report No. 10 (New York: Council on Foreign Relations).

    • Search Google Scholar
    • Export Citation
  • Chinn, Menzie, and Hiro Ito, 2005, “Current Account Balances, Financial Development and Institutions: Assaying the World ‘Savings Glut,’NBER Working Paper 11761 (Cambridge, Massachusetts: National Bureau of Economic Research).

    • Search Google Scholar
    • Export Citation
  • Chinn, Menzie, and Eswar Prasad, 2003, “Medium-Term Determinants of Current Accounts in Industrial and Developing Countries: An Empirical Exploration,Journal of International Economics, Vol. 59, No. 1, pp. 4776.

    • Search Google Scholar
    • Export Citation
  • Choudhri, Ehsan, and Mohsin Khan, 2005, “Real Exchange Rates in Developing Countries: Are Balassa-Samuelson Effects Present?IMF Staff Papers, Vol. 52 (December), pp. 387409.

    • Search Google Scholar
    • Export Citation
  • Debelle, Guy, and Hamid Faruqee, 1996, “What Determines the Current Account? A Cross-Sectional and Panel Approach,IMF Working Paper 96/58 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • De Gregorio, José, Alberto Giovannini, and Holger Wolf, 1994, “International Evidence on Tradables and Non-tradables Inflation,European Economic Review, Vol. 38 (June), pp. 122544.

    • Search Google Scholar
    • Export Citation
  • Demirgüç-Kunt, Asli, and Enrica Detragiache, 2005, “CrossCountry Empirical Studies of Systemic Bank Distress: A Survey,IMF Working Paper 05/96 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Edwards, Sebastian, 1989, Real Exchange Rates, Devaluation and Adjustment: Exchange Rate Policy in Developing Countries (Cambridge, Massachusetts: MIT Press).

    • Search Google Scholar
    • Export Citation
  • Edwards, Sebastian, and Jonathan D. Ostry, 1990, “Anticipated Protectionist Policies, Real Exchange Rates, and the Current Account: The Case of Rigid Wages,Journal of International Money and Finance, Vol. 9 (June), pp. 20619.

    • Search Google Scholar
    • Export Citation
  • Edwards, Sebastian, and Jonathan D. Ostry, 1992, “Terms of Trade Disturbances, Real Exchange Rates, and Welfare: The Role of Capital Controls and Labor Market Distortions,Oxford Economic Papers, Vol. 44, pp. 2034.

    • Search Google Scholar
    • Export Citation
  • Edwards, Sebastian, and Miguel Savastano, 2000, “Exchange Rates in Emerging Economies: What Do We Know? What Do We Need to Know?” in Economic Policy Reform: The Second Stage, ed. by Anne O. Krueger (Chicago: University of Chicago Press).

    • Search Google Scholar
    • Export Citation
  • European Bank for Reconstruction and Development (EBRD), 2005, Transition Report (London).

  • Faruqee, Hamid, 1995, “Long-Run Determinants of the Real Exchange Rate: A Stock-Flow Perspective,IMF Staff Papers, Vol. 42 (March), pp. 80107.

    • Search Google Scholar
    • Export Citation
  • Federal Reserve Bank of Kansas City, 2004, “Global Demographic Change: Economic Impacts and Policy Challenges,” proceedings of a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming (Aug. 26–28).

    • Search Google Scholar
    • Export Citation
  • Froot, Kenneth A., and Kenneth S. Rogoff, 1995, “Perspectives on PPP and Long-Run Real Exchange Rates,” in Handbook of International Economics, Vol. 3, ed. by Gene M. Grossman Kenneth Rogoff (Amsterdam: Elsevier), pp. 164788.

    • Search Google Scholar
    • Export Citation
  • Gagnon, Joseph, 1996, “Net Foreign Assets and Equilibrium Exchange Rates: Panel Evidence,U.S. Federal Reserve Board International Finance Discussion Paper No. 574 (Washington).

    • Search Google Scholar
    • Export Citation
  • Ghosh, Atish R., and Jonathan D. Ostry, 1997, “Macroeco-nomic Uncertainty, Precautionary Saving, and the Current Account,Journal of Monetary Economics, Vol. 40, No. 1, pp. 12139.

    • Search Google Scholar
    • Export Citation
  • Goldfajn, Ilan, and Rodrigo Valdes, 1999, “The Aftermath of Appreciations,Quarterly Journal of Economics, Vol. 114 (February), pp. 22962.

    • Search Google Scholar
    • Export Citation
  • Gonzalo, Jesus, and Clive Granger, 1995, “Estimation of Common Long-Memory Components in Cointegrated Systems,Journal of Business and Economic Statistics Vol. 13, No. 1 (January), pp. 2735.

    • Search Google Scholar
    • Export Citation
  • Gruber, Joseph, and Steven Kamin, 2005, “Explaining the Global Pattern of Current Account Imbalances,U.S. Federal Reserve Board International Finance Discussion Paper No. 846 (Washington).

    • Search Google Scholar
    • Export Citation
  • Hayashi, Fumio, 1997, Understanding Saving: Evidence from the United States and Japan (Cambridge, Massachusetts: MIT Press).

  • Higgins, Matthew, 1998, “Demography, National Savings, and International Capital Flows,International Economic Review, Vol. 39, No. 2, pp. 34369.

    • Search Google Scholar
    • Export Citation
  • Hinkle, Lawrence E., and Peter J. Montiel, 1999, Exchange Rate Misalignment: Concepts and Measurement for Developing Countries (Oxford: Oxford University Press).

    • Search Google Scholar
    • Export Citation
  • Im, Kyung So M. Hashem Pesaran and Yongcheol Shin, 2003, “Testing for Unit Roots in Heterogeneous Panels,Journal of Econometrics, Vol. 115 (July), pp. 5374.

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, 2006, World Economic Outlook (Washington, April).

  • Isard, Peter, and Hamid Faruqee, 1998, Exchange Rate Assessment: Extension of the Macroeconomic Balance Approach, IMF Occasional Paper No. 167 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Isard, Peter, Russell Kincaid, and Martin Fetherston, 2001, Methodology for Current Account and Exchange Rate Assessment, IMF Occasional Paper No. 209 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Kao, Chihwa, 1999, “Spurious Regression and Residual-Based Tests for Cointegration in Panel Data, Journal of Econometrics, Vol. 90 (May), pp. 144.

    • Search Google Scholar
    • Export Citation
  • Kao, Chihwa, Min-Hsien Chiang 2000, “On the Estimation and Inference of a Cointegrated Regression in Panel Data,Advances in Econometrics, Vol. 15, pp. 179222.

    • Search Google Scholar
    • Export Citation
  • Lane, Philip, and Gian Maria Milesi-Ferretti, 2001, “LongTerm Capital Movements,” in NBER Macroeconomics Annual 2001 (Cambridge, Massachusetts: National Bureau of Economic Research).

    • Search Google Scholar
    • Export Citation
  • Lane, Philip, and Gian Maria Milesi-Ferretti, 2002, “External Wealth, the Trade Balance, and the Real Exchange Rate,European Economic Review, Vol. 46 (June), pp. 104971.

    • Search Google Scholar
    • Export Citation
  • Lane, Philip, and Gian Maria Milesi-Ferretti, 2004, “The Transfer Problem Revisited: Net Foreign Assets and Real Exchange Rates,Review of Economics and Statistics, Vol. 86 (November), pp. 84157.

    • Search Google Scholar
    • Export Citation
  • Lane, Philip, and Gian Maria Milesi-Ferretti, 2007a, “A Global Perspective on External Positions,” in G7 Current Account Imbalances: Sustainability and Adjustment, ed. by Clarida Richard (Chicago: Chicago University Press for NBER).

    • Search Google Scholar
    • Export Citation
  • Lane, Philip, and Gian Maria Milesi-Ferretti, 2007b, “The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970–2004,Journal of International Economics, Vol 73, No. 2 (November), pp. 22350.

    • Search Google Scholar
    • Export Citation
  • Lee, Jaewoo, and Menzie D. Chinn, 2007, “Current Account and Real Exchange Rate Dynamics in the G7 Countries,Journal of International Money and Finance, Vol. 25, No. 2, pp. 25774.

    • Search Google Scholar
    • Export Citation
  • Lee, Jaewoo, and Man-Keung Tang, 2007, “Does Productivity Growth Appreciate the Real Exchange Rate?Review of International Economics, Vol. 15 (February), pp. 16487.

    • Search Google Scholar
    • Export Citation
  • Levin, Andrew, Chien-Fu Lin, and Chia-Shang James Chu, 2002, “Unit Root Tests in Panel Data: Asymptotic and Finite-Sample Properties,Journal of Econometrics, Vol. 108 (May), pp. 124.

    • Search Google Scholar
    • Export Citation
  • MacDonald, Ronald, and Luca Antonio Ricci, 2005The Real Exchange Rate and the Balassa-Samuelson Effect: The Role of the Distribution Sector,Pacific Economic Review, Vol. 10, No. 1, pp. 2948.

    • Search Google Scholar
    • Export Citation
  • MacDonald, Ronald, and Luca Antonio Ricci, 2007, “Real Exchange Rates, Imperfect Substitut-ability, and Imperfect Competition,Journal of Macroeconomics, Vol. 29, No.4, pp. 63964.

    • Search Google Scholar
    • Export Citation
  • Maeso-Fernandez, Francisco, Chiara Osbat, and Bernd Schnatz, 2004, “Towards the Estimation of Equilibrium Exchange Rates for CEE Acceding Countries: Methodological Issues and a Panel Cointegration Perspective,ECB Working Paper 353 (Frankfurt: European Central Bank).

    • Search Google Scholar
    • Export Citation
  • Meese, Richard A., and Kenneth Rogoff, 1983, “Empirical Exchange Rate Models of the Seventies: Do They Fit out of Sample?Journal of International Economics, Vol. 14 (February), pp. 324.

    • Search Google Scholar
    • Export Citation
  • Obstfeld, Maurice 2004, “External Adjustment,Review of World Economics, Vol. 140, No. 4, pp. 54168.

  • Obstfeld, Maurice Kenneth Rogoff, 1996, Foundations of International Macroeconomics (Cambridge, Massachusetts: MIT Press).

  • Ostry, Jonathan D., 1988, “The Balance of Trade, the Terms of Trade, and the Real Exchange Rate: An Intertemporal Optimizing Framework,Staff Papers, International Monetary Fund, Vol. 35, No. 4, pp. 54173.

    • Search Google Scholar
    • Export Citation
  • Ostry, Jonathan D., 1991, “Tariffs, Real Exchange Rates, and the Trade Balance in a Two-Country World,European Economic Review, Vol. 35, No. 5, pp. 112742.

    • Search Google Scholar
    • Export Citation
  • Ostry, Jonathan D., 1994, “Government Purchases and Relative Prices in a Two-Country World,Economic Record, Vol. 70, No. 209 (June), pp. 14961.

    • Search Google Scholar
    • Export Citation
  • Ostry, Jonathan D., Carmen M. Reinhart, 1992, “Private Saving and Terms of Trade Shocks: Evidence from Developing Countries,Staff Papers, International Monetary Fund, Vol. 39 (September), pp. 495517.

    • Search Google Scholar
    • Export Citation
  • Pedroni, Peter 2000, “Fully Modified OLS for Heterogeneous Cointegrated Panels,Advances in Econometrics, Vol. 15, pp. 93130.

  • Phillips, Peter C.B., and Bruce E. Hansen, 1990, “Statistical Inference in Instrumental Variables Regression with I(1) Processes,Review of Economic Studies, Vol. 57, pp. 99125.

    • Search Google Scholar
    • Export Citation
  • Ricci, Luca Antonio, Gian Maria Milesi-Ferretti, and JaeWoo Lee, 2008, “Real Exchange Rates and Fundamentals: A Cross-Country Perspective,IMF Working Paper 08/13 (Washington).

    • Search Google Scholar
    • Export Citation
  • Rogoff, Kenneth, 1996, “The Purchasing Power Parity Puzzle,Journal of Economic Literature, Vol. 34 (June), pp. 64768.

  • Sachs, Jeffrey D., and Andrew Warner, 1995, “Economic Reform and the Process of Global Integration,Brookings Papers on Economic Activity: 1, Brookings Institution, pp. 1118.

    • Search Google Scholar
    • Export Citation
  • Stock, James, and Mark Watson, 1993, “A Simple Estimator of Cointegrating Vectors in Higher Order Integrated Systems,Econometrica, Vol. 61, No. 4, pp. 783820.

    • Search Google Scholar
    • Export Citation
  • Taylor, Alan, 2001, “A Century of Current Account Dynamics,Journal of International Money and Finance, Vol. 21 (November), pp. 72548.

    • Search Google Scholar
    • Export Citation
  • Wacziarg, Romain, and Karen H. Welch, 2003, “Trade Liberalization and Growth: New Evidence,” NBER Working Paper 10152 (Cambridge, Massachusetts: National Bureau of Economic Research).

    • Search Google Scholar
    • Export Citation