On the Contingency of Equilibrium Exchange Rates with Time Consistent Economic Policies

Abstract

Equilibrium exchange rate theories (FEER, BEER and NATREX) make the assumption that the Real Equilibrium Exchange Rate (RER) is independent from internal equilibrium and economic policies. We develop a model in which economic policies depend on the minimisation of an intertemporal loss function and we show that in a Wage Setting-Price Setting (WS-PS) framework, the RER depends on the policymakers' objectives, making the previous assumptions highly questionable. We provide some results on the impact of policymakers' preferences on the long run exchange rate and discuss the concept of inflation illusion. In our model, the long run (equilibrium) exchange rate is contingent on policymakers' preferences, implying that equilibrium exchange rates estimates must be treated with great caution.