Concepts of Equilibrium Exchange

Rates
Rebecca Driver and Peter Westaway
Choosing how to measure equilibrium

• What time frame?

• What definition of the exchange rate?

• Modelling option

• Choosing between models

 What time frame are we interested in?

• Short run
• Market equilibrium
• Current equilibrium

• Medium run

• Long run
 What definition of the exchange rate?

• Real vs Nominal?

• Bilateral vs Effective?

• Choice of price index?

 Exchange rate measure (cont.)
• Terms of trade (price of exports compared to
imports)
• Price of tradable goods or output prices
• Whole economy measures defined using
• Consumer price indices
• Unit labour costs

• Internal real exchange rate (tradables to non-

tradables)
 Implementing an approach

• Modelling option
• Model based
• Estimation

• Choosing between models

• Predictability
• Co-movements
• Long run
 Arbitrage based approaches

• Uncovered Interest Parity (UIP)

• Purchasing Power Parity (PPP)

• Balassa-Samuelson

Empirical Justification?
 Short run models
• Monetary models
• Capital Enhanced Equilibrium Exchange Rates
(CHEERs)
• Intermediate-term model-based EERs
(ITMEERs)
• Behavioural Equilibrium Exchange Rates
(BEERs)
Empirical justification?
 Underlying Balance Models:
The Medium Run
Internal and external balance

• Fundamental Equilibrium Exchange Rates

(FEERs)
• Desired Equilibrium Exchange Rates
(DEERs)

Empirical justification?
 Fig 1: Stylised Model of the Underlying Balance
model
Real Exchange External Balance
Rate
Y>Y*
Trend Current Account
(Y=Y* and YW=Y W*)
Y<Y*

ER

S-I Norm Current Account

 Longer run measures

• Permanent Equilibrium Exchange Rates

(PEERs)

• Atheoretical Permanent Eers (APEERs)

• Natural Real Exchange Rate (Natrex)

Empirical justification?
 Understanding the role of shocks

• Structural Vector Autoregressions (SVARs)

• Dynamic Stochastic General Equilibrium

Models (DGSE)

Empirical justification?
 Table 1: Summary of Empirical Approaches to
Estimating Equilibrium Exchange Rates
UIP PPP Balassa- Monetary CHEERs ITMEERs BEERs FEERs DEERs APEERs PEERs NATREX SVARs DSGE
Samuelson Models

Name Uncovered Purchasing Balassa- Monetary Capital Intermediate Behavioural Fundamental Desired Atheoretical Permanent Natural Structural Dynamic
Interest Power Samuelson and Enhanced Term Model Equilibrium Equilibrium Equilibrium Permanent Equilibrium Real Vector Stochastic
Parity Parity Portfolio Equilibrium Based Exchange Exchange Exchange Equilibrium Exchange Exchange Auto General
balance Exchange Equilibrium Rates Rates Rates Exchange Rates Rates Regression Equilibrium
models Rates Exchange Rates models
Rates

Theoretical The Constant PPP for PPP in PPP plus Nominal UIP Real UIP with Real As with None As BEERs As with Real Models
Assumptions expected Equilibrium tradable long run nominal UIP including a a risk premia exchange rate FEERs, but FEERs, but exchange designed to
change in Exchange goods. (or short without risk risk premia and/or compatible the with the rate explore
the Rate Productivity run) plus premia plus expected expected with both definition assumption affected by movements
exchange differentials demand future future internal and of external of portfolio supply and in real
rate between for movements in movements in external balance balance (so demand and/or
determined traded and money. real exchange real exchange balance. Flow based on domestic (but not nominal
by interest nontraded rates rates not full stock optimal real interest nominal) exchange
differentials goods determined determined equilibrium policy rate is equal shocks in rates in
by by to the world the long run response to
fundamentals fundamentals rate). shocks.

Relevant Short run Long run Long run Short run Short run Short run Short run Medium run Medium Medium / Medium / Long run Short (and Short and
Time (forecast) (forecast) (also forecast) Run Long run Long run long) run long run
Horizon

Statistical Stationarity Stationary Non- Non- Stationary, None Non- Non- Non- Non- Non- Non- As with As with
Assumptions (of change) stationary stationary with stationary stationary stationary stationary stationary stationary theoretical theoretical
emphasis on (extract (extract
speed of permanent permanent
convergence component) component)

Dependent Expected Real or Real Nominal Nominal Future change Real Real Real Real Real Real Change in Change
Variable change in nominal in the Effective Effective the Real relative to
the real or Nominal long run
nominal steady state

Estimation Direct Test for Direct Direct Direct Direct Direct Underlying Underlying Direct Direct Direct Direct Simulation
Method stationarity Balance Balance
 Modelling Accession countries

What features do we want?

• Traded v nontraded goods?

• Pricing to market?
– In which direction?
• Risk premium?

Will depend on the question

 Choosing an entry rate for EMU
• Actual exchange rate = short run equilibrium
= medium run equilibrium = long run
equilibrium
• Life is simple!!!!
– With a small caveat about bilateral v effective
exchange rates

• Sadly life is rarely simple!

 Exchange rates when shocks occur

• The exchange rate as a shock absorber v

source of noise

• Good reasons why short, medium and long

run equilibria differ

• Important to understand why

 Different time horizons
Exchange rate

Short Run

Medium Run

Long Run

time
 Entry rates when shocks occur
• Entry rate = medium run  short run rate
– Inflationary consequences

• Costs determined by:

– reason why actual  medium run equilibrium
– speed of adjustment to FEER outside EMU

• Choice of entry date important

 References

Westaway (2003) “Modelling the transition to

EMU”, HM Treasury.
http://www.hm-
treasury.gov.uk/documents/the_euro/assessme
nt/studies/euro_assess03_studwiltshire.cfm
 Conclusions

• Remember the question of interest

• Models may have equal analytical status

• What will be important is their significance

for task