The IMF Research Bulletin, a quarterly publication, selectively summarizes research and analytical work done by various departments at the IMF, and also provides a listing of research documents and other research-related activities, including conferences and seminars. The Bulletin is intended to serve as a summary guide to research done at the IMF on various topics, and to provide a better perspective on the analytical underpinnings of the IMF’s operational work.


The IMF Research Bulletin, a quarterly publication, selectively summarizes research and analytical work done by various departments at the IMF, and also provides a listing of research documents and other research-related activities, including conferences and seminars. The Bulletin is intended to serve as a summary guide to research done at the IMF on various topics, and to provide a better perspective on the analytical underpinnings of the IMF’s operational work.

Hamid Faruqee

Exchange rates are a core area of the IMF’s surveillance responsibilities. In the late 1970s, the IMF’s Articles of Agreement were amended to reflect the new reality of floating exchange rates. The revised guidelines made it clear that surveillance would include freely floating rates, in particular, “behavior of the exchange rate that appears to be unrelated to underlying economic and financial conditions.” Responding to this challenge, research at the IMF has analyzed exchange rates on several fronts. In an applied context, efforts have focused on developing a multilateral framework for estimating equilibrium exchange rates. Another key component of the research agenda covers the empirical analysis of the nature and determinants of exchange rate fluctuations. This article briefly summarizes recent studies on these topics at the IMF.

The IMF has established a long tradition of research and operational work to better understand exchange rate behavior, advise countries on exchange rate policy, and assess the prevailing alignment of currencies.1 A major applied component of this research has been the development of a multilateral framework for exchange rate assessment.2 In the latest installment of this work, Isard and others (2001) provide an update of the “macrobalance approach” which examines the consistency of exchange rates with medium-term “fundamentals” through the lens of internal and external balance.3 Internal balance relates to an economy operating at potential output, while external balance refers to an equilibrium saving-investment balance. Thus, the IMF framework for exchange rate assessment relies heavily on current account assessments—the analysis of which has recently been extended to cover a large set of countries, including emerging market economies.4

After Meese and Rogoff (1983) set the bar for evaluating empirical exchange rate models, many studies have undertaken the frustrating, if not futile, attempt to outperform a random walk in terms of forecasting accuracy.5 While success at explaining short-term movements remains elusive, empirical models of exchange rates have fared better over longer time horizons. Tests of the monetary approach to exchange rate determination, for example, have shown some success at long-horizon forecasts, though not without controversy.6 Based on a simulation study of earlier work, Berkowitz and Giorgianni (2001) find little support for long-horizon predictability of the monetary model among the major currencies, except in rare cases where short-run predictability was also evident.7

Another popular empirical approach relies on uncovered interest rate parity, wherein expected changes in the (log) exchange rate correspond, one-for-one, to interest rate differentials. Testing this relationship at both short and long horizons, Chinn and Meredith (2001a, 2001b) obtain sensible coefficients in the latter context with G-7 data, while Flood and Rose (forthcoming) report results that are decidedly mixed for a broader set of countries at higher frequencies.8 MacDonald and Nagayasu (2000) uncover evidence of a long-run connection between real interest rate differentials and real exchange rates in a panel of 14 industrial countries, suggesting that countries with relatively high real interest rates tend to have relatively weak or depressed real exchange rates.9

IMF Staff Papers

Volume 49, Issue 2

Explaining Russia’s Output Collapse: Aggregate Sources and Regional Evidence

Irina Dolinskaya

The Long-Run Behavior of Commodity Prices: Small Trends and Big Variability

Paul Cashin and C. John McDermott

Human Capital Convergence: A Joint Estimation Approach

Randa Sab and Stephen C. Smith

The Inverted Fischer Hypothesis: Inflation Forecastability and Asset Substitution

Woon Gyu Choi

The Optimal Subsidy to Private Transfers Under Moral Hazard

Ralph Chami and Connel Fullenkamp

Uncovered Interest Parity in Crisis

Robert P. Flood and Andrew K. Rose

IMF Staff Papers, the IMF’s scholarly journal, edited by Robert Flood, publishes selected high-quality research produced by IMF staff and invited guests on a variety of topics of interest to a broad audience, including academics and policymakers in IMF member countries. The papers selected for publication in the journal are subject to a rigorous review process using both internal and external referees. The journal and its contents (including an archive of articles from past issues) are available online at the Research at the IMF website at

Testing the validity of purchasing power parity (PPP) as a benchmark for exchange rate behavior has also received considerable attention from researchers.10 More recently, studies have sought to explain the so-called “PPP puzzle” (summarized by Rogoff, 1996), around the fact that deviations from PPP are extremely persistent.11 Chen and Rogoff (2002) find that the terms of trade play a significant role in understanding real exchange rate behavior in Canada, Australia, and New Zealand, though a significant degree of “nagging persistence”—that is, the PPP puzzle—remains.12 Comparing international to intranational real exchange rates, Bayoumi and MacDonald (1999) find that the former group displays mean-reversion while relative prices within the U.S. and Canada do not, suggesting that the comparative role of nominal versus real shocks may help explain these differences.13 Investigating real exchange rate behavior over the business cycle, Chadha and Prasad (1997) identify nominal and real demand shocks (rather than supply shocks) as the primary sources of medium-term variation in Japan’s real exchange rate.14 MacDonald and Ricci (2001, 2002) find that including sectoral productivity and competitiveness measures in their panel estimates substantially reduces the half-life of deviations in the real exchange rate from long-run equilibrium.15

Pursuing the issue of long-run equilibrium has led several researchers to consider (stochastic) trends in real exchange rates. Employing a balance of payments framework, a series of papers explore long-run co-movements of real exchange rates with variables such as net foreign assets, the terms of trade, and productivity—where gains in each tend to raise or appreciate the real exchange rate.16 Using this approach, Alberola and others (forthcoming) construct the bilateral exchange rate implications consistent with their multilateral analysis to generate empirical assessments for currencies inside and outside the euro area.17 Lane and Milesi-Ferretti (2002b) separate the positive relationship between net foreign assets (NFA) and real exchange rates into two parts: (1) a negative relationship between NFA and the trade balance, and (2) a negative relationship between the trade balance and the real exchange rate.18 Clark and MacDonald (1999, 2000) further extend the reduced-form approach in several ways to better estimate the permanent component of real exchange rates.19

Taking an asset market perspective, Faruqee and Redding (1999) examine possible nonlinear dynamics in G-7 exchange rates based on a noise-trader model.20 Rapid (nonlinear) adjustment in market rates helps explain the fact that short-run changes in exchange rates are not normally distributed but, instead, display excess kurtosis or “fat tails.”21 Based on a simple asset-pricing model with rational expectations, Bartolini and Giorgianni (2001) find excess volatility in bilateral exchange rates for the major currencies, despite placing minimal restrictions on the “fundamentals.”22 Flood and Rose (1999) document that the higher exchange rate volatility accompanying a move toward more flexible rates occurs without an underlying increase in the volatility of macroeconomic “fundamentals.”23 They suggest that changes in the structure of financial markets and the role of portfolio balance shocks may be responsible.24 Jeanne and Rose (2002) present a more detailed theoretical explanation of this universal phenomenon based on a noise-trader model.25

Empirical analysis of exchange rates is a daunting challenge to researchers. Nevertheless, as this selection of studies indicates, IMF research continues to make significant contributions to the empirical literature on exchange rate behavior, and these issues will no doubt engage researchers well into the future.

IMF Occasional Paper No. 209

Methodology for Current Account and Exchange Rate Assessments

Peter Isard, Hamid Faruqee, G. Russell Kincaid, and Martin J. Fetherston

In exercising its surveillance responsibilities, the IMF makes judgments about the extent to which prevailing exchange rates deviate from levels consistent with medium-run fundamentals. This paper describes a methodology, developed by an interdepartmental Coordinating Group on Exchange Rates (CGER), for assessing exchange rates among industrial country currencies. The assessments employ a multilateral framework, drawing on both a macroeconomic balance approach and purchasing power parity considerations. Although CGER’s assessments are not precise, the framework imposes consistency across currencies and over time. The interpretation given to substantial deviations between prevailing exchange rates and their medium-run equilibrium levels emphasizes that such deviations can persist for long periods and do not necessarily establish a case for policy actions, for example, when deviations stem from cyclical considerations. However, these deviations sometimes reveal tensions in the global configuration of current account balances and exchange rates. The paper also describes preliminary work to develop indicators of current account sustainability for emerging market economies.

Detailed contents of IMF Occasional Papers are available at the Research at the IMF website at

IMF Occasional Paper No. 210

IMF-Supported Programs in Capital Account Crises

Atish Ghosh, Timothy Lane, Marianne Schulze-Ghattas, Aleš Bulíř, Javier Hamann, and Alex Mourmouras

During the 1990s, a number of emerging market countries faced “capital account” crises, in which sudden reversals of capital inflows, reflecting shifts in market sentiment, forced abrupt current account adjustments, often with pervasive macroeconomic consequences. Although concerns about the sustainability of external policies played a role in crisis propagation, it does not explain the magnitude of the adjustments. Other vulnerabilities, such as public debt dynamics, a risky public debt management strategy, or pervasive financial sector weaknesses were critical in changing investor confidence. The paper discusses three main issues. First, did the IMF-supported program’s design adequately take into account what was distinctive about these crises? Second, can macroeconomic policies influence the adjustment process once a crisis has erupted? Third, what is the role of structural reforms in crisis resolution? Eight IMF-supported programs are reviewed: Turkey (1994), Mexico (1995), Argentina (1995), Thailand (1997), Indonesia (1997), Korea (1997), the Philippines (1997), and Brazil (1998).

Detailed contents of IMF Occasional Papers are available at the Research at the IMF website at


See Jacques J. Polak, “Fifty Years of Exchange Rate Research and Policy at the International Monetary Fund,” IMF Staff Papers, Vol. 42, No. 4, pp. 734–62, 1995; See also Jeromin Zettelmeyer, “Exchange Rate Regimes in Developing Countries and Emerging Markets,” IMF Research Bulletin, Vol. 2 (March), 2001.


Paul Masson, Peter Isard, and Hamid Faruqee, “A Macroeconomic Balance Framework for Estimating Equilibrium Exchange Rates,” in Equilibrium Exchange Rates, Ronald MacDonald and Jerome Stein, eds. (Boston: Kluwer Academic Press, 1999), pp. 103–33; Peter Isard and Hamid Faruqee, eds., Exchange Rate Assessment: Extensions of the Macrobalance Approach, IMF Occasional Paper No. 167, 1998; Peter B. Clark, Leonardo Bartolini, Tamim Bayoumi, and Steven Symansky, Exchange Rates and Economic Fundamentals: A Framework for Analysis, IMF Occasional Paper No. 115, 1994.


Peter Isard, Hamid Faruqee, G. Russell Kincaid, and Martin Fetherston, Methodology for Current Account and Exchange Rate Assessments, IMF Occasional Paper No. 209, 2001.


Menzie Chinn and Eswar Prasad, “Medium-Term Determinants of Current Accounts in Industrial and Developing Countries: An Empirical Exploration,” Journal of International Economics (forthcoming).


Richard Meese and Kenneth Rogoff, “Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?” Journal of International Economics, Vol. 14 (February), pp. 3–24, 1983.


Kenneth Rogoff, “Monetary Models of Dollar/Yen/Euro Nominal Exchange Rates: Dead or Undead?” Economic Journal, Vol. 109 (November), pp. F655–F659, 1999; Barry Johnston and Yan Sun, “Some Evidence on Exchange Rate Determination in Major Industrial Countries,” IMF Working Paper 97/98, 1997.


Jeremy Berkowitz and Lorenzo Giorgianni, “Long-Horizon Exchange Rate Predictability” Review of Economics and Statistics, Vol. 83 (February), 2001.


Menzie Chinn and Guy Meredith, “Testing Uncovered Interest Rate Parity at Short and Long Horizons” (unpublished; Washington: IMF), 2001a; idem, “Long Horizon Uncovered Interest Rate Parity,” NBER Working Paper No. 6797, 2001b; and Robert P. Flood and Andrew K. Rose, “Uncovered Interest Parity in Crisis: The Interest Rate Defense in the 1990s,” IMF Staff Papers (forthcoming).


Ronald MacDonald and Jun Nagayasu, “The Long-Run Relationship Between Real Exchange Rates and Real Interest Rate Differentials: A Panel Study,” IMF Staff Papers, Vol. 47, No. 1, pp. 89–102, 2000.


Paul A. Cashin and C. John McDermott, “An Unbiased Appraisal of Purchasing Power Parity,” IMF Working Paper 01/196, 2001; Karl Habermeier and Mario Mesquita, “Long-Run Exchange Rate Dynamics: A Panel Data Study,” IMF Working Paper 99/50, 1999; Jun Nagayasu, “Does the Long-Run PPP Hypothesis Hold for Africa? Evidence from Panel Co-Integration Study,” IMF Working Paper 98/123, 1998.


Kenneth Rogoff, “The Purchasing Power Parity Puzzle,” Journal of Economic Literature, Vol.34, pp. 647–68, 1996.


Yu-chin Chen and Kenneth Rogoff, “Commodity Currencies and Empirical Exchange Rate Puzzles,” IMF Working Paper 02/27, 2002.


Tamim Bayoumi and Ronald MacDonald, “Deviations of Exchange Rates from Purchasing Power Parity: A Story Featuring Two Monetary Unions,” IMF Staff Papers, Vol. 46, No. 1, pp. 89-104, 1999;


Bankim Chadha and Eswar Prasad, “Real Exchange Rates Fluctuations and the Business Cycle: Evidence from Japan,” IMF Staff Papers, Vol. 44, No. 3, 1997; Pierre-Richard Agenor, Alexander W. Hoffmaister; Carlos Laranjo Medeiros, “Cyclical Fluctuations in Brazil’s Real Exchange Rate: The Role of Domestic and External Factors,” IMF Working Paper 97/128, 1997.


Ronald MacDonald and Luca Ricci, “PPP and the Balassa Samuelson Effect: The Role of the Distribution Sector,” IMF Working Paper 01/38, 2001; idem, “Purchasing Power Parity and New Trade Theory,” IMF Working Paper 02/32, 2002; Mark De Broeck and Torsten Slok, “Interpreting Real Exchange Rate Movements in Transition Countries,” IMF Working Paper 01/56, 2001.


Hamid Faruqee, “Long-Run Determinants of the Real Exchange Rate: A Stock-Flow Perspective,” IMF Staff Papers, Vol. 42, No. 1, pp. 80–107, 1995; Philip R. Lane and Gian Maria Milesi-Ferretti, “Long-Run Determinants of the Irish Real Exchange Rate,” Applied Economics, Vol.34 (March), pp. 549-53, 2002a.


Enrique Alberola, Susana Crevero, Humberto Lopez, and Angel Ubide, “Quo vadis, Euro?” European Journal of Finance (forthcoming).


Philip R. Lane and Gian Maria Milesi-Ferretti, “External Wealth, the Trade Balance, and the Real Exchange Rate,” European Economic Review, Vol. 46, No. 7, 2002b; “The External Wealth of Nations: Measures of Foreign Assets and Liabilities for Industrial and Developing Countries,” Journal of International Economics, Vol. 55 (December), pp. 263–94, 2001.


Peter Clark and Ronald MacDonald, “Exchange Rates and Economic Fundamentals: A Methodological Comparison of BEERs and FEERs,” Equilibrium Exchange Rates, Ronald MacDonald and Jerome Stein, eds., (London: Kluwer Academic Publishers, 1999); idem,” Filtering the BEER: A Permanent and Transitory Decomposition,” IMF Working Paper 00/144, 2000; Claudio Paiva “Competitiveness and the Equilibrium Exchange Rate in Costa Rica,” IMF Working Paper 01/2, 2001; Tarhan Feyzioglu, “Estimating the Equilibrium Real Exchange Rate: An Application to Finland,” IMF Working Paper 97/109, 1997.


Hamid Faruqee and Lee Redding, “Endogenous Liquidity Providers and Exchange Rate Dynamics” Canadian Journal of Economics, Vol. 32 (August), pp. 976-94, August 1999.


Lee Redding and Hamid Faruqee, “Asset Markets and Endogenous Liquidity,” Scottish Journal of Political Economy, Vol. 48 (May), pp. 196–209, 2001.


Leonardo Bartolini and Lorenzo Giorgianni, “Excess Volatility of Exchange Rates with Unobservable Fundamentals,” Review of International Economics, Vol. 9 (August), 2001.


Robert P. Flood and Andrew K. Rose, “Understanding Exchange Rate Volatility Without the Contrivance of Macroeconomics,” Economic Journal, Vol. 109 (November) 1999; Kenneth Rogoff,” Perspectives on Exchange Rate Volatility,” in International Capital Flows, ed. by Martin Feldstein (Chicago: University of Chicago Press and the NBER: 1999), pp. 441–53.


Robert P. Flood and Nancy P. Marion, “Self-Fulfilling Risk Predictions: An Application to Speculative Attacks,” Journal of International Economics, Vol. 50, No. 1, pp. 245–68, 2000.


Olivier Jeanne and Andrew Rose, “Noise Trading and Exchange Rate Regimes,” Quarterly Journal of Economics, Vol. 117 (May) 2002.

IMF Research Bulletin, June 2002
Author: International Monetary Fund. Research Dept.