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A more detailed discussion is provided in Isard and Faruqee (1998), Isard et al. (2001), and Lee et al. (2008). For a survey of related methodologies used to estimate equilibrium exchange rates, see Williamson (1994) and Hinkle and Montiel (1999).
CGER exchange rate assessments are classified by the IMF as “Strictly Confidential,” due to potential market sensitivity of IMF views on exchange rate misalignments (although CGER assessments do not necessarily reflect the IMF’s official view on exchange rates). As a result, this paper does not provide information on assessed misalignments for specific countries. However, the methodologies used by CGER are public (see, for example, Lee et al. 2008), and interested parties can produce similar misalignment estimates based on publicly available information.
See, for example, Timmerman (2007). The purpose of this paper is not to perform robustness tests of a specific model; extensive tests of the current CGER models were performed, and are reported in Lee et al. (2008). Rather, we are evaluating the predictive performance of CGER assessments, which are based not only on several exchange rate models, but also reflect subjective views of IMF staff, e.g., medium-term projections of macroeconomic variables that are inputs into the CGER assessments.
We use 3- and 5-year horizons—as opposed to a shorter horizon of, say, one year—because evidence from error-correction models (e.g., Ricci et al. 2008) suggests slow convergence of the actual REER to the equilibrium REER, with an estimated convergence half-life of about 2½ years.
Countries are not identified, for reasons described in footnote 2.
The Hausman (1978) test that the error term is uncorrelated with the regressors rejects the null hypothesis for many of the regressions below, suggesting that fixed-effects estimation is more appropriate than random-effects estimation. Similar results obtain when using random-effects estimation (not reported).
The “fundamentals” used to calculate the equilibrium exchange rate at time t reflects not just current macroeconomic conditions at time t, but also projections of future macroeconomic conditions made at time t. To the extent that changes between time t and t+k were in line with these projections, there is no “change in fundamentals;” it is only when realizations are different from the projected path, or there is a shift in projections, that we have a “change in fundamentals.”
Robust standard errors are computed to address the serial correlation induced by the use of overlapping observations, as noted in Hansen and Hodrick (1980). Country fixed effects are not reported in Tables 1 and 2, but follow a pattern very similar to the mean prediction errors reported in Figure 1; the correlation between them is 0.98.
Countries are named in Table 3 because no information is provided on country-specific misalignments. Diagnostics using the midpoint of the CGER assessment range produce similar results, and are not reported here. In particular, there was no systematic difference in either the MSE or the direction of change statistic between using the midpoint and the MB estimate.
In additional regressions (not reported) we also controlled for changes in interest rates over the forecast horizon, in case changes in monetary policy might have influenced the behavior of the exchange rate, but this had no significant influence on the results.
There are two reasons why the change in ES fundamentals was not included in the regression. First, unlike the MB and ERER approaches, the ES approach is not based on a regression and, as such, has no explicit fundamental determinants. The “fundamentals” implicit in the NFA-stabilizing CA are medium-term growth and the NFA position, both of which change very slowly. Second, changes in ES fundamentals are dominated by changes to the underlying medium-term CA, which is already captured in the change in MB fundamentals. In fact, the correlation between the changes in MB and ES fundamentals is extremely high (0.93), so that when one also includes the change in ES fundamentals, both it and the change in MB fundamentals are insignificant.