Fundamental Equilibrium Exchange Rate Research Articles

Exchange rates and fundamentals: Forecasting with long maturity forward rates

We show that in a popular model of exchange rate determination, the unobserved expected future exchange rate can be substituted with the observed forward exchange rate. This allows the derivation of a new error-correction forecasting model, which approximates the gap between the fundamental equilibrium exchange rate and the actual exchange rate with the long-maturity forward exchange rate. Our out-of-sample forecasting results for major currencies are unprecedented. The forecasting model is simple, easy to replicate, and the data we use are available in real time and not subject to revisions.

Does exchange rate misalignments lead changes in macroeconomic fundamentals?

This article aimed at verifying the reliability of equilibrium exchange rate (EER) concepts by exploring if exchange rate misalignments are leading to changes in macroeconomic fundamentals. The authors focused on G10 currencies and the three most popular EER models which the IMF regularly uses within the External Balance Assessment: Purchasing Power Parity, Behavioural EER and Fundamental EER. In methodological terms, the study applied the cross-sectional predictability approach developed by Sarno and Schmeling (2014), which ranks countries on the basis of the scale of EER misalignment to check if this ranking helps to predict key macro variables. The results indicate that EER misalignment contains cross-sectional predictive power and allows forecasting real effective exchange rates, short-term interest rates and current account balance differences across countries.

Real exchange rate effect on economic growth: comparison of fundamental equilibrium exchange rate and Balassa–Samuelson based Rodrik approach

ABSTRACT This study reproduces the work of Dani Rodrik on real exchange rate undervaluation and economic growth for 93 countries over the period 1990–2018. While the empirical literature on the dynamics between the real exchange rate1 1 It is a measure of the bilateral real exchange rate with respect to the US dollar. and economic growth is relatively comprehensive, little has been done to compare these dynamics within economies using the Balassa–Samuelson-based Rodrik approach (BS) and the fundamental equilibrium exchange rate model (FEER). This research, to the best of the authors’ knowledge, is one of the first to compare the fundamental equilibrium exchange rate model and Balassa–Samuelson-based Rodrik approach and use dynamic estimation on the Rodrik approach. The findings of the study support Rodrik’s conclusion that undervaluation has a significant impact on economic growth, although the results of FEER are more significant than those of BS. Furthermore, the first lag of undervaluation has a significant effect on economic growth.

REER Imbalances and Macroeconomic Adjustments: Evidence from the CEMAC Zone

The European Monetary Union (EMU) crisis holds special lessons for existing monetary unions. We assess the behaviour of real effective exchange rates (REERs) of members of the Central African Economic and Monetary Community zone with respect to their long-term equilibrium paths. A reduced form of the fundamental equilibrium exchange rate model is estimated for associated misalignments. Our findings suggest that for majority of countries, macroeconomic fundamentals have the expected associations with the exchange rate fluctuations. The analysis also reveals that only the REER adjustments of Cameroon and Gabon are significant in restoring the long-term equilibrium in the event of a shock. The Cameroonian economic fundamentals of terms of trade, government expenditure and openness have different long-term relations with the REER in comparison to those of other member states. There is no need for an adjustment in the level of the peg based on the present quantitative analysis of REER paths. JEL: F31, F33, F42, F61, O55

REER Imbalances and Macroeconomic Adjustments: Evidence From the CEMAC Zone

The EMU crisis holds special lessons for existing monetary unions. We assess the behavior of real effective exchange rates (REERs) of members of the Central African Economic and Monetary Community (CEMAC) zone with respect to their long-term equilibrium paths. A reduced form of the fundamental equilibrium exchange rate (FEER) model is estimated and associated misalignments. Our findings suggest that for majority of countries, macroeconomic fundamentals have the expected associations with the exchange rate fluctuations. The analysis also reveals that only the REER adjustments of Cameroon and Gabon are significant in restoring the long-term equilibrium in event of a shock. The Cameroonian economic fundamentals of terms of trade, government expenditure and openness have different long-term relations with the REER in comparison to those of other member states. There is no need for an adjustment in the level of the peg based on the present quantitative analysis of REER paths.

Exchange Rate Dynamics and Monetary Integration in the EAC Countries

A major challenge for most countries in Sub-Saharan Africa is the evaluation of the exchange rate. This is more so in the East African Community (EAC) where macroeconomic and exchange rate management has been particularly challenged by massive foreign aid inflows, which are partly a result of the Heavily Indebted Poor Countries initiative and other debt reliefs. In addition, improved macroeconomic management in the last decade attracted both short- and medium- to long-term inflows to the region, as foreign investors turn to developing and emerging economies for yield. In this paper, we estimate the fundamental equilibrium exchange rate model for all the countries in the EAC and assess the convergence of existing exchange rate regimes in the EAC. Our main contribution is that this exercise could serve as useful background for the ultimate decision of which exchange rate management framework will best fit the region during the transition period to monetary union.

Internal Devaluations and Equilibrium Exchange Rates: new evidences and perspectives for the EMU

ABSTRACTFrom the onset of the euro crisis to the Brexit vote, we have witnessed impressive reductions of current account imbalances in peripheral countries of the euro area. These reductions can be the result of either a compression of internal demand or an improvement in external competitiveness. In this paper, we compute exchange rate misalignments within the euro area to assess whether peripheral countries have managed to improve their external competitiveness. After controlling for the reduction of business cycle synchronization within the EMU, we find that peripheral countries have managed to reduce their exchange rate misalignments thanks to internal devaluations. To some extent, these favourable evolutions reflect improvements in external competitiveness. Nevertheless, these gains could only be temporary if peripheral countries do not improve their non-price competitiveness, their trade structures and their international specializations in the long run.Abbreviations: EMU, European Monetary Union; FEER, Fundamental Equilibrium Exchange Rate; SMIM, Symmetric Matrix Inversion Method; BEER, Behavioural Equilibrium Exchange Rate; PPP, Purchasing Parity Power; OCI, Own Country Included; IMF, International Monetary Fund; OECD, Organisation for Economic Co-operation and Development; NIESR, National Institute of Economic and Social Research.

The Estimation of Equilibrium Exchange Rates in Malaysia: Evidence Using FEER Model

The study of exchange rate behavior is important to identify the currency either experiencing an overvaluation or undervaluation. The traditional theory to estimate exchange rates behavior is the Law of One Price (henceforth LOP). This theory suggests that the price levels would be the same between two countries after converting their price into a common currency. However, the LOP does not take into account the real macroeconomic fundamentals factors. Hence, this model is seen missing to explain the possible a particular exchange rate is influenced by macroeconomics fundamentals. Therefore, this study is aim to investigates the behavior of exchange rate movement and identify the determinants of macroeconomics fundamentals on the exchange rates in Malaysia. By using fundamental equilibrium exchange rates (FEER) model, this study adopts the bound testing popularized by Pesaran et al., and autoregressive distributed lag (ARDL) to examine the long run relationships (or cointegration) among the variables and the dynamic effect within variables in the short run.

English

The underlying study focuses on assessing the real exchange rate in Egypt during the period 1999-2012. In particular, the paper estimates the Real Exchange Rate (RER) misalignments in Egypt during the period under investigation. This is implemented through carrying out two main steps: first, the observed real exchange rate is calculated. Then, the Equilibrium Real Exchange Rate (ERER) is estimated using three different techniques from the methodology spectrum of the empirical literature. These methodologies are widely used to estimate the ERER in both developing and developed countries alike; namely, the Purchasing Power Parity (PPP) approach; the Fundamental Equilibrium Exchange Rate (FEER) approach and Edwards Model (1989). Fortunately, the three techniques yield consistent results concerning the undervaluation and overvaluation episodes. Evidently, the REER appears to be misaligned during the period 2001-2009: undervalued during 2003-2007, overvalued 2001-2002 and 2008-2012. The paper concludes that the Egyptian Pound is recently overvalued; although all the applied approaches indicate different misalignment magnitudes, they all show a growing trend in the relative prices in favor of our trading partners. It is recommended to narrow down these deviations; the REER has to be devaluated by a range of 9 to 13 percent in order for the Egyptian products not to lose their competitiveness in the international markets.   Key words: Exchange rate, misalignments, Egypt.&nbsp

Global imbalances: Should we use fundamental equilibrium exchange rates?

The reduction of global imbalances observed during the climax of crisis is incomplete. In this context, currencies' realignments are still proposed to ensure global macroeconomic stability. These realignments are based on equilibrium rates derived from equilibrium exchange rate models. Among these models, we have the fundamental equilibrium exchange rate model introduced by Williamson (1994). This approach is often labelled as normative mainly because the equilibrium is not uniquely determined. If the FEER is not related either in the short run or in the long run to the real exchange rates, we see no clear justification to intervene in foreign exchange markets based on these equilibrium rates. In this case, the FEER does not include any element of long run predictive value and should not be used to reduce global imbalances. This paper provides panel empirical evidences that the FEER is related to real exchange rate in the long run and thus could be a useful tool to prevent the resurgence of large global imbalances and associated risks.

Real Effective Exchange Rate Imbalances and Macroeconomic Adjustments: Evidence from the CEMAC Zone

We assess the behavior of real effective exchange rates (REERs) of members of the CEMAC zone with respect to their long-term equilibrium paths. A reduced form of the fundamental equilibrium exchange rate (FEER) model is estimated and associated misalignments are derived for the period 1980 to 2009. Our findings suggest that for majority of countries, macroeconomic fundamentals have the expected associations with the exchange rate fluctuations. The analysis also reveals that, only the REER adjustments of Cameroon and Gabon are significant in restoring the long-term equilibrium in event of a shock. The Cameroonian economic fundamentals of terms of trade, government expenditure and openness have different long-term relations with the REER in comparison to those of other member states. Ultimately, there is no need for an adjustment in the level of the peg based on the present quantitative analysis of REER paths.

Out-of-Sample Performance of the Macroeconomic Balance Approach to the Real Exchange Rate in Sub-Saharan Africa

This paper tests the performance of the macroeconomic balance (MB) approach (or fundamental equilibrium exchange rate approach) in predicting future movements of real exchange rates (RERs) and current accounts. The analysis is conducted for countries in Sub-Saharan Africa (SSA). Econometric evidence shows that a random walk beats current account and RER misalignments from the MB approach in out-of-sample forecasting accuracy. However, the MB approach helps to predict the direction of change of these variables.

Explaining the Appreciation of the Brazilian Real

ABSTRACT This article seeks to identify factors explaining the appreciation of the Brazilian real observed since 2003, which was temporarily interrupted only during episodes of financial turbulence. Net foreign assets and the productivity differential relative to Brazil's main trade partners are found to be significant determinants of the real effective exchange rate in the long run. In the short term, exchange-rate developments are mostly explained by movements in net foreign assets. The production of oil is also found to explain developments in the real effective exchange rate in the long run. These results are robust to a wide range of tests. There is evidence of an overvaluation of the real in 2010, but the extent of the misalignment is hard to gauge. Fundamental Equilibrium Exchange Rate estimations point to an overvaluation between 3%–10% in 2010. Dynamic simulations of behavioral exchange-rate equations generally suggest an overvaluation of between 10%–20%. However, these estimations remain subject to large uncertainties.

Exchange Rate Misalignment - The Case of the Chinese Renminbi

Assessing exchange rate misalignment is not an easy task. With reference to the debate on the value of China’s currency, the renminbi (RMB), this article highlights a few challenges in properly assessing the extent of currency misalignment. The results derived from the fundamental equilibrium exchange rate (FEER) approach and the Penn effect regression are used to illustrate the sensitivity of misalignment estimate to assumptions of the key parameters in a given model, sampling uncertainty, serial correlation adjustment, and data revision. It is shown that both the sign and the magnitude of a misalignment estimate could be dramatically affected by these factors.

GLOBAL IMBALANCES AND THE PRETENCE OF KNOWING FUNDAMENTAL EQUILIBRIUM EXCHANGE RATES

AbstractGlobal imbalances remain a key challenge for the world economy. In this regard, it has often been argued that insufficient exchange rate adjustment prevents their dissolution. Obviously, such a line of reasoning crucially depends on the methodologies used for assessing the ‘fair value’ of a currency. This paper looks specifically at estimates of fundamental equilibrium exchange rates (FEER) and shows that these are highly sensitive to the chosen assumptions. The present study cautions against using such models too mechanistically and giving too much confidence to the precision of obtained magnitudes of misalignment.

Structural Breaks and the Equilibrium Chinese Yuan/US Dollar Real Exchange Rate: A FEER Approach

AbstractThis paper examines the equilibrium Chinese yuan/US dollar (CNY/USD) real exchange rate within the framework of the fundamental equilibrium exchange rate (FEER) model. Endogenous structural breaks are allowed for in all cointegration relationships. Macroeconomic fundamentals that affect medium‐term savings and investment and hence, the sustainable current account, are also highlighted. A unique set of quarterly data for the post‐reform period (1982–2009) is constructed. This paper finds structural breaks in all trade and the sustainable current account equations. The misalignment rates show that the real exchange rate was overvalued in most years until 2003, followed by undervaluation during 2004–09. However, the average misalignment rates and revaluation required to correct this undervaluation are not as large as suggested by previous studies, with the undervaluation rate declining sharply in 2009. Further, misalignment rates are computed using a sustainable current account of 3%. The findings suggest such exogenous input leads to results biased towards larger undervaluation.

Mapping a country's competitive position: a real exchange rate approach

PurposeThe observed real exchange rate, measured as an effective index of real labour costs, may serve as a base for the evaluation of the Portuguese economy's competitiveness. The purpose of this paper is to evaluate the positioning of the real exchange rate, throughout time, against a benchmark that guarantees external macroeconomic equilibrium (balanced fundamental account).Design/methodology/approachThis paper uses the effective real exchange rate as an indicator of Portugal's competitive position in relation to its major trading partners (fundamental equilibrium exchange rate approach using the unit labour costs).FindingsThe authors found evidence that the real exchange rate has been persistently overvalued since the early 1990s. The evolution of this situation, which is harmful for the national economy, does not evidence the return to a path that may ensure external equilibrium for Portugal. The results show evidence of significant overvaluation of the Portuguese real exchange rate when compared to its estimated equilibrium level. In order to achieve a balanced fundamental account and considering a margin of error of 5 per cent, the real exchange rate needs to depreciate between 27.69 and 30.61 per cent.Originality/valueThe relevance of the real effective exchange rate as a macroeconomic indicator arises from its role as a measure of national competitiveness. Computed as a measure of the difference of international prices, adjusted to the same unit of measurement, it represents the relative price of goods between countries, determining where this same price may be higher or lower. According to Krugman and Obstfeld, the manipulation of the real effective exchange rate allows one country to adjust its level of competitiveness against its trading partners.

Estimating Consistent Fundamental Equilibrium Exchange Rates

This paper sets forth a new methodology for obtaining a consistent set of exchange rate realignments needed to accomplish international adjustment in current account imbalances to reach fundamental equilibrium exchange rates (FEERs). The approach is named the symmetric matrix inversion method (SMIM). It is symmetric in that ir treats all countries considered equally rather than seeking exact adjustment for the United States and obtaining other adjustments residually. Country-specific impact parameters based on assumed trade elasticities are applied to a target set of changes in current accounts as percentages of GDP to obtain a corresponding set of target changes in real effective (trade-weighted) exchange rates. A matrix inversion technique is then applied to identify the corresponding set of changes in bilateral exchange rates against the dollar needed to approach as closely as possible the target set of effective exchange rate changes.

Exchange Rate Dynamics and Fundamental Equilibrium Exchange Rates

The paper investigates if the most popular alternative to the purchasing parity power approach (PPP) to estimate equilibrium exchange rates, the fundamental equilibrium exchange rate (FEER) influences exchange rate dynamics in the long run. For a large panel of industrialized and emerging countries and on the period 1982-2007, we detect the presence of unit roots in the series of real effective exchange rates and in the series of FEERs. We find and estimate a cointegration relationship between real effective exchange rates and FEERs. The results show that the FEER has a positive and significant influence on exchange rate dynamics in the long run.

EQUILIBRIUM REAL EXCHANGE RATES

This paper analyzes the role of the real exchange rate in macroeconomic equilibrium. The supply-side equilibrium exchange rate, that level of the real exchange rate at which (relative) inflation is constant, is derived from a simple macro-model and related to the standard NAIRU model. The stabilizing role of monetary policy in adjustment towards the supply-side equilibrium exchange rate is analyzed both before and after entry to the exchange rate mechanism of the European Monetar System. Resolution of the conflict between supply-side and external equilibrium produces a stricter definition of the fundamental equilibrium exchange rate of J. Williamson. Copyright 1992 by Blackwell Publishers Ltd and The Victoria University of Manchester