Abstract
The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
This paper explores a number of methodological issues that arise in the calculation of exchange rates consistent with macroeconomic equilibrium, that is, internal and external balance. Although we use the term “desired equilibrium exchange rate” (DEER), it is not that the exchange rate that is desired for its own sake, but rather that it is consistent with achieving “desired” positions of internal and external balance.
A partial equilibrium, comparative static analysis is presented and the methodology is applied to the breakup of the Bretton Woods exchange rate system. Given estimates of the full employment level of output and of the desired current account, the DEER is defined as the level of the real effective exchange rate consistent with achieving these objectives in the medium term. Alternative estimates of DEERs are obtained using different assumptions about underlying parameters and variables. The results indicate that changes in the underlying assumptions can have a significant impact--between 10 and 30 percent in effective terms--on estimated DEERs. This wide range of estimates underlines the need for caution in identifying any given exchange rate as “the” appropriate equilibrium value. Nevertheless, all of the calculations imply that the U.S. dollar was overvalued and the yen undervalued at their 1970 parities.
The dynamic interaction between current accounts and net foreign assets is explored by taking account of certain hysteresis effects. Given that deviations of the actual exchange rate from the DEER generate changes in the current account and hence movements in the amount of equilibrium debt service, it is clear that the level of the real exchange rate consistent with medium-term external balance will shift as long as the actual real exchange rate deviates from the DEER. Thus, the final DEER determined will not be independent of the path chosen towards it.
Finally, the analysis uses a more general equilibrium approach based on MULTIMOD simulations. Because MULTIMOD is a fully-specified dynamic macroeconomic model, all major simultaneous effects are taken into account. The aim is to see what difference a full model simulation makes to the calculated change in the real effective exchange rate simulation, as well as to estimate the likely domestic economic effects of a change in the external balance. Because the exchange rate is determined endogenously in the model, it is necessary to use a “forcing” or exogenous variable to change the exchange rate in order to achieve the desired change in the external balance. The specific type of exogenous variable will have an effect on the entire macroeconomic system and will therefore influence the level of the real effective exchange rate that is consistent with the desired positions of internal and external balance. In particular, the two types of shocks considered here (changes in currency preferences and fiscal policy) have very different implications for medium-term real output and interest rates and ultimately result in some differences in the estimated DEERs.