Artis, Michael J., and M.P. Taylor, “DEER Hunting: Misalignment, Debt Accumulation, and Desired Equilibrium Exchange Rates,” International Monetary Fund, Working Paper No. WP/93/48 (Washington, June 1993).
Artus, Jacques, “Methods of Assessing the Long-Run Equilibrium Value of an Exchange Rate,” DM/77/124, International Monetary Fund (December 1977).
Artus, Jacques, and Rudolph R. Rhomberg, “A Multilateral Exchange Rate Model,” International Monetary Fund (Washington), Staff Papers, Vol. 20 (1973), pp. 591–611.
Barrell, R., and S. Wren-Lewis, “Equilibrium Exchange Rates for the G7,” Discussion Paper No. 323 (Centre for Economic Policy Research: London, 1989).
Branson, William, “Exchange Rate Dynamics and Monetary Policy,” in Asser Lindbeck, ed., Inflation and Employment in Open Economies (North Holland, 1979).
Church, Keith B., “Properties of Fundamental Equilibrium Exchange Rate Models of the UK Economy,” National Institute Economic Review (August 1992).
Cross, R., “On the Foundations of Hysteresis in Economic Systems,” International Centre for Macroeconomic Modelling, University of Strathclyde, Discussion Paper No. 4 (1992).
Currie, D., and S. Wren-Lewis, “Evaluating Blueprints for the Conduct of International Macropolicy,” American Economic Review, Vol. 79 (1989), pp. 264–69.
de Vries, Margaret Garritsen, The International Monetary Fund. 1966-71 Volume 1. Narrative (International Monetary Fund: Washington, 1976).
Frenkel, J.A., and M. Goldstein, “A Guide to Target Zones,” International Monetary Fund (Washington), Staff Papers, Vol. 33 (1986), pp. 633–73.
Garber, Peter M., “The Collapse of the Bretton Woods Fixed Exchange Rate System,” in Michael D. Bordo and Barry Eichengreen (eds.), A Retrospective on the Bretton Woods System (University of Chicago Press: Chicago, 1993).
International Monetary Fund, “Issues in the Assessment of the Exchange Rates of Industrial Countries,” Occasional Paper No. 29 (Washington: International Monetary Fund, 1984).
International Monetary Fund, “The Role of Exchange Rates in the Adjustment of International Payments: A Report by the Executive Directors” (Washington: International Monetary Fund, 1970).
Masson, P., S. Symansky, and G. Meredith, “MULTIMOD Mark II: A Revised and Extended Model,” Occasional Paper No. 71 (Washington: International Monetary Fund, 1990).
McKinnon, Ronald I., “The Rules of the Game: Money in Historical Perspective,” Journal of Economic Literature, Vol. 31 (1993), pp. 1–44.
Nurske, R., Conditions of International Monetary Equilibrium, Essays in International Finance, No. 4 (Princeton, N.J.: Princeton University Press, 1945).
Taylor, M.P., “Exchange Rate Behavior Under Alternative Exchange Rate Regimes,” in P. Kenen (ed.) Understanding Interdependence: The Macroeconomics of the Open Economy, Princeton University Press (Princeton, New Jersey, Fall 1994).
Volcker, Paul A., and Yoyoo Gyohten, Changing Fortunes: The World’s Money and the Threat to American Leadership (Times Books: New York, 1992).
Williamson, John, “Equilibrium Exchange Rates: An Update,” unpublished paper, Institute for International Economics (Washington, October 1990).
Williamson, John, and M. Miller, “Target Zones and Indicators: A Blueprint for the International Coordination of Economic Policy” (Washington: Institute for International Economics, 1987).
Wren-Lewis, Simon, “On the Analytical Foundations of the Fundamental Equilibrium Exchange Rate,” in C.P. Hargreaves (ed.), Macroeconomic Modeling of the Long Run (Algershot: Edward Elgar, 1992), pp. 323–338.
Wren-Lewis, Simon, P. Westaway, S. Soteri, and R. Barrell, “Evaluating the United Kingdom’s Choice of Entry Rate Into the ERM,” Manchester School, Vol. 59, Supplement (1991), pp. 1–22.
Economists, International Monetary Fund. The views expressed here are those of the authors and do not necessarily reflect those of the staff or the Board of the I.M.F. They gratefully acknowledge the helpful comments of Charles Adams, Jacques Artus, Leonardo Bartolini, Ulrich Baumgartner, Sterie Beza, Jack Boorman, Bankim Chadha, Hamid Faruqee, and Morris Goldstein, without in any way implicating them in any of the views expressed in this paper. This paper will appear in a volume on equilibrium exchange rates edited by John Williamson that will be published by the Institute for International Economics.
The medium term in this context means the period needed for output to return to potential and for changes in competitiveness to be reflected in trade volumes, which would appear to be in the range of four to six years.
For a description of the MULTIMOD macroeconomic model, see Masson, Symansky, and Meredith (1990). Long-run exchange rate elasticities were used, since the focus of the analysis is on medium-term adjustment. For output, short-run absorption elasticities were used since these are more appropriate for cyclical disturbances.
Fiscal policy also provides a potential policy tool for moving the current exchange rate to its equilibrium level, rather than as a major independent factor in the DEER calculation. This use of fiscal policy in this manner is described in Section IV below.
There are a number of descriptions of the collapse of the Bretton Woods by academics (Williamson, 1977 and Garber, 1993), institutional historians (de Vries, 1976), and policy makers (Solomon, 1982, and Volcker and Gyohten, 1992).
The elasticities are shown in Table 1, panel A. The first two columns show the estimated absorption elasticities used in MULTIMOD (MULTIMOD uses absorption as the activity variable in the export and import equations). The output elasticities shown in the next two columns, which are the numbers actually used in the calculation, take account of the multiplier interaction between changes in real net exports and absorption given a fixed level of output. These elasticities are estimated using data from the post-1972 floating exchange rate period. No account was taken of the possibility that trade elasticities may have varied between the Bretton Woods era and the subsequent floating exchange rate regime.
The aggregate effect is made up of the real exchange rate elasticities for exports and for imports plus an adjustment for the multiplier effects of these movements in exports and imports on absorption. These adjustments tend to increase the overall real exchange rate elasticity. For example, an appreciation in the real exchange rate lowers exports and raises imports. This in turn lowers net exports which, for a given level of domestic output, raises domestic absorption and hence raises the demand for imports.
The methodology used here is similar in some respects to that described in Artus and Rhomberg (1973). Their approach, which is also comparative static, involves the use of a highly disaggregated model of traded and nontraded goods. There are supply and demand equations for a number of traded goods and demand equations for nontraded goods. Where this approach differs from that used in this section in that the response of trade flows reflects both supply and demand responses to exchange rate changes. Both approaches are partial equilibrium in that they do not include induced effects on domestic output arising from exchange rate changes and the interaction between trade flows, net foreign assets, and net interest payments. These macroeconomic effects are taken into account in the MULTIMOD simulation results reported in Section IV.
No attempt is made to reproduce the calculations of appropriate exchange rates made at the time of the Smithsonian Agreement by the IMF and OECD, which used a set of desired adjustments in the current account which were different from the uniform 1 percent surplus assumed here. Rather, as noted above, the objective here is to illustrate the potential use of DEER calculations.
In 1971 the United States ran a current account deficit of just over 0.1 percent of GDP. The goal of the United States was a turnaround of some $13 billion (about 1.2 percent of GDP) in the current account, which implies a target surplus of about 1 percent of GDP. It should be noted that the IMF staff does not regularly compute the type of desired current account positions that are referred to in this paper; the current account positions here are used for illustrative purposes only.
The importance of Canada in U.S. trade can be seen from the fact that the bilateral misalignments against all currencies except the Canadian dollar were over 17 percent.
Since the Canadian dollar was floating throughout this period, the average market rate was used as the “parity” in both 1970 and 1972.
The nominal parities against the dollar agreed at the Smithsonian meeting were 308 yen, 3.22 DM, 5.12 French francs, 582 lira, and 0.384 pounds sterling.
Inflation was higher in Europe and Japan than in the United States over this period, hence the reported bilateral exchange rates for the yen and European currencies are lower than the actual Smithsonian parities (the opposite is true for the Canadian dollar). The largest adjustment is for the United Kingdom, whose GDP deflator rose by 7 percent more than that in the United States over the period.
It should be noted that these calculations were made in the same way as in the base case, the only difference being the magnitude of the external balance objective.
The aggregate external position of the major industrial countries deteriorated by around half a percent of GDP between 1971 and 1972. Accordingly, the current account target was lowered from 1 percent of GDP to ½ percent for each country in the calculations.
It might be objected that the short-run elasticities differ from the medium-run elasticities used in constructing the DEER. A further adjustment could be made for any such differences.
In fact, the precise calculations were slightly different because we used percentage differences rather than logarithmic differences. A spread sheet program was used to perform the calculations.
Although the dynamics of trade equations indicate an adjustment period on the order of five years, it takes significantly longer for MULTIMOD to converge to a steady state. In some cases, the figures reported below represent an overshooting of the target, while for other countries the external balance targets have not yet been achieved after five years.
These targeted changes in the trade balances in percent of GDP are: United States (1.13), Japan (−1.49), Germany (0.55), United Kingdom (−0.89), France (0.92), Italy (−0.72), and Canada (0.62).
In general, the change in the former in less than the change in the latter. This reflects the fact that the export prices for one country are influenced by the export prices of competing countries in the short-to-medium run, whereas import and GDP deflators are less closely connected. Thus in MULTIMOD Japanese export prices are estimated to be much more closely tied to competitor’s prices than U.S. export prices, and therefore, the real effective exchange rate change rising relative export prices is much smaller than using PGDP/PM in Japan, as compared with the United States
It should be noted that while the analysis in Section II does take some account of the effect of changes in absorption on trade flows, it does not include any induced changes in real output.
Although there are several other exogenous variables that could have been used to attain the current account targets, two likely candidates were infeasible. Monetary policy could not be used since it is neutral in MULTIMOD after several years. Surprisingly, productivity changes could not be used to attain a current account target. An increase in potential output raises real income and lowers prices, and these have opposite effects on the trade balance. The net effect, which depends on several underlying parameters, was very small and therefore productivity shocks could not be used to achieve a given level of the current account.
An alternative method for making the calculation would have been to lower the baseline level of output by the amount of the gap. As MULTIMOD is fairly linear in the neighborhood of potential output, this alternative calculation would have yielded results similar to those reported in the text.
The estimated excess of actual output over potential output in 1971 in France may well be too high. Nonetheless, this simulation result illustrates the importance of taking account of cyclical developments in calculating DEERs.
In some cases, however, the MULTIMOD results appear to reflect specific assumptions, such as the assumption that all foreign assets are denominated in U.S. dollars.
In this connection it should be noted that the I.M.F. staff in its work on exchange rates tries to encourage countries to pursue appropriate underlying economic policies and would be sensitive to the implications of the different adjustment paths described here.