Filtering the BEER: A permanent and transitory decomposition

Abstract

In this paper, we extend the behavioral equilibrium exchange rate (BEER) approach which identifies an estimated equilibrium relationship between the real exchange rate and economic fundamentals. Here, the economic fundamentals (real interest rate differential, net foreign assets, and relative price of nontraded/traded goods) are decomposed using Johansen cointegration methods into transitory and permanent components, with the latter used to estimate the permanent equilibrium exchange rate (PEER) for the U.S. and Canadian dollars and the pound sterling. The BEER and the PEER move closely together for the U.S. and Canadian dollars and generally track the actual exchange rate. By contrast, for the pound sterling, the BEER and the PEER diverge sharply, with the latter following the actual exchange rate quite closely.