Exchange Rate Economics: Theories and Evidence

242 Equilibrium exchange rates
US it is only 0.06) and the PEER measure,by definition,filters this out of the data
leaving only the permanent component. Clark and MacDonald (2000) therefore
argue that supplementing the BEER approach with a PEER decomposition may
be useful for assessment purposes,especially if the driving fundamentals contain
important transitory elements.
Alberola et al. (1999) estimate BEER type relationships (the cointegrating vector
comprises the real exchange rate,net foreign assets and a Balassa–Samuelson term)
for a variety of industrial country real effective exchange rates,using the Engle–
Granger two-step method. PEERs are then constructed to gauge the extent of
currency misalignments. For example,at the end of 1998 they estimated that
the euro was undervalued by 4.5%,the dollar overvalued by 7.5% and the
pound sterling is overvalued by 15.7%. Bilateral estimates of equilibrium were
then constructed and these show that the euro was undervalued against the dollar
at the end of 1998 by 7.5%,and this had widened to an undervaluation
of around 20% by the end of 1999. Similarly,the dollar proved to be strongly
overvalued against the yen,by 13.64% and to a lesser extent against the Canadian
dollar by 4.63%.
Makrydakis et al. (2000) use the methods of Johansen to estimate BEER relationships
for a synthetic times series of the euro,over the period 1980Q1–99Q2.
The conditioning variables are a relative productivity term (the ratio of GDP to
total employment),net foreign assets and a real interest differential. All of the
coefficients on these variables enter with the correct sign and their magnitude is
similar to those obtained for the original EMU currencies,such as the German
mark,although the net foreign asset term is statistically insignificant. The implied
PEER is then calculated using the methods of Granger and Gonzalo (1995) and
this is interpreted as the equilibrium exchange rate. They show that the euro was
1.5% above its equilibrium at the end of the first quarter in 1999,although this
had declined to a misalignment of only 0.34% by the second quarter of 1999.
Makrydakis et al. also use their estimated PEER to describe the historical evolution
of the real synthetic euro.
Hoffman and MacDonald (2000) present PEER estimates which are subject
to both a cointegration constraint and to the additional constraints implied by a
structural VAR. In particular,they consider a vector comprising a real income
differential,the real effective exchange rate and the real interest differential (this
choice being motivated by an extended Mundell–Fleming–Dornbusch model). Six
country systems are considered (the US,Japan,Germany,France,Italy,the UK
and Canada) and the estimation period is 1978,quarter 2 to 1997 quarter 4.
In contrast to the studies considered in the previous sub-section,permanent and
transitory components are identified solely from the cointegration information in
the data. Real and nominal shocks are then disentangled using the identification
methods of Blanchard and Quah. In sum,Hoffman and MacDonald find that
the majority of real exchange rate variation is explained by real shocks,although
nominal shocks have an important role to play as well.
Using the Granger–Gonzalo decomposition,Hoffman and MacDonald generate
permanent and transitory decompositions and they find that the bulk of