Abstract
This compilation of summaries of Working Papers released during January-June 1995 is being issued as a part of the Working Paper series. It is designed to provide the reader with an overview of the research work performed by the staff during the period. Authors of Working Papers are normally staff members of the Fund or consultants, although on occasion outside authors may collaborate with a staff member in writing a paper. The views expressed in the Working Papers or their summaries are, however, those of the authors and should not necessarily be interpreted as representing the views of the Fund. Copies of individual Working Papers and information on subscriptions to the annual series of Working Papers may be obtained from IMF Publication Services, International Monetary Fund, 700 19th Street, Washington, D.C. 20431. Telephone: (202) 623-7430 Telefax: (202) 623-7201.
Recently there has been a resurgence of interest in modeling “long-run” real and nominal exchange rates. In large part, such interest has arisen because the stylized fact that freely floating exchange rates are rarely, if ever, at their equilibrium levels has generated a desire to understand just how far away from equilibrium a current exchange rate might be. For bilateral exchange rates, a growing body of evidence suggests that some form of stable ‘long-run’ relationship exists between exchange rates and fundamentals, particularly relative prices. This latter relationship, however, does not conform exactly to what would conventionally be regarded as purchasing power parity (PPP), in that often, particularly for U.S. dollar bilateral rates, standard symmetry and degree one homogeneity restrictions (implied by absolute PPP) are strongly rejected and the implied mean reversion of the real exchange rate is very slow. There would therefore appear to be more to exchange rates than simply relative prices.
In this paper, the recent work on long-run exchange rate relationships is taken as the point of departure and combined with a theoretical model of exchange rate determination--a “hybrid asset market” or “balance of payments” model--to examine the determinants of nominal exchange rates. From an empirical perspective, the model has two appealing features. It incorporates a key element of the asset approach to exchange rate modeling, namely, that an asset price is related to the present value of expected future fundamentals, along with elements of a more traditional balance of payments or portfolio balance approach, in which real factors can have an important bearing on the nominal exchange rate, even in equilibrium. A key aspect of this latter feature is the issue of sustainability.
The hybrid asset market or balance of payments model considered in this paper, labeled an “eclectic exchange rate model” (EERM), is implemented for the effective exchange rates of the deutsche mark, Japanese yen, and U.S. dollar over the period 1973 Q3 to 1993 Q4. It is demonstrated that the EERM produces sensible estimates of the long-run values of these exchange rates, whereas simple PPP does not. Interestingly, the actual value of the Japanese yen stays very close to its equilibrium value throughout the period, whereas both the deutsche mark and dollar are often quite far away; this is especially so for the U.S. dollar in the period coinciding with its dramatic appreciation in the early 1980s. The short-run dynamic equations implied by the long-run exchange rate systems are deemed reasonably successful on the basis of standard criteria. The paper concludes by arguing that the approach adopted warrants further attention, particularly in terms of the data requirements necessary to implement it for bilateral exchange rates.