Exchange Rate Economics: Theories and Evidence

9 Equilibrium exchange rates
Measurement and misalignment
9.1 Introduction
In this chapter we return to the issue of equilibrium exchange rates. The chapter
is intended to have two main themes. First,we noted in Chapters 2 and 3 that
PPP does not seem to provide a good measure of a country’s equilibrium exchange
rate. Are there any alternative measures that can be used for this purpose? As we
saw in Chapter 3,one explanation for the poor performance of PPP is that there
are real factors driving real exchange rates and once the real rate is conditioned on
these factors many of the puzzles associated with PPP disappear. In this chapter we
provide an overview of different alternative approaches to measuring equilibrium
exchange rates that rely on such real factors. The second theme we address here is
how to use an equilibrium exchange rate to assess if a currency is overvalued or not.
Calculating equilibrium exchange rates and assessment issues have become especially
topical of late for a variety of reasons. First,a number of countries – such as the
current group of accession countries,and the UK and Sweden – have an interest in
knowing the appropriate exchange rate for entry into the euro area (either in terms
of the rate at which to participate in an ERM II arrangement or the appropriate
rate at which to lock a currency permanently to the euro). Second,the behaviour of
certain currencies,such as the initial sharp and sustained fall in the external value
of the euro immediately after its inception in 1999,the sustained appreciated
value of sterling in the late 1990s and the post 2005 behaviour of the Chinese renminbi
against the US dollar,has generated a debate about the sources of exchange
rate movements. Does such behaviour represent movements in the underyling
equilibria,and therefore the currencies are correctly priced,or do they represent
misalignments? Clearly,to answer these kinds of questions requires some measure
of the equilibrium exchange rate. Knowledge of equilibrium exchange rates is also
desirable in the wider context of reform of the international monetary system (IMS).
For example,proposals for introducing a greater degree of fixity into the IMS (such
as those of Williamson 1988 and McKinnon 1988) – between the yen,dollar and
euro – requires knowledge of the appropriate rate at which to lock currencies or
the appropriate central rate of a target zone/crawling peg arrangement.
Purchasing power parity (PPP) is often the measure economists first turn to
when asked to think about the issue of equilibrium exchange rates and exchange