Exchange Rates and Economic Fundamentals: A Methodological Comparison of Beers and Feers

Abstract

The analysis of exchange rate behavior has been a perennial topic in international monetary economics. One strand of this literature relates to the explanation of observed movements in nominal and real exchange rates in terms of relevant economic variables. A different strand focuses on assessing exchange rates relative to economic fundamentals and coming to a judgement as to whether a particular exchange rate is misaligned, i.e., over- or undervalued. One approach taken in this latter strand of research that has been developed by Williamson (1994) involves the calculation of what is called the Fundamental Equilibrium Exchange Rate (FEER). In this approach the equilibrium exchange rate is defined as the real effective exchange rate that is consistent with macroeconomic balance, which is generally interpreted as when the economy is operating at full employment and low inflation (internal balance) and a current account that is sustainable, i.e., that reflects underlying and desired net capital flows (external balance). This exchange rate concept is denoted as “fundamental” in that it abstracts from short-term factors and emphasizes instead determinants that are important over the medium term. An assessment of a country’s exchange rate can be made by comparing its current level with the calculated FEER