Exchange Rate Economics: Theories and Evidence

Equilibrium exchange rates 249
although the figure is likely to be higher in the long-run. An estimate of C T /Y N
may be obtained from the current account ratio:
CA
Y
= Y T − C T − iD
,(9.34)
Y
where Y (GDP) and D (net external debt) are expressed in terms of traded goods.
Taking the situation of the US in 2001,where a current account deficit as a
proportion of GDP of 4.4% existed,Obstfeld and Rogoff assume Y T /Y is 25%
and iD/Y is 1.2% (which implies an interest rate of 6% and a GDP to net debt
ratio of 20%). If for external balance,the ratio of the current account to income,
CA/Y ,falls to zero the drop in net imports of tradables would need to be 16%
(i.e. 4.4 / 28.2). With prices fully flexible and θ equal to unity,the relative price
of non-traded to traded goods, p,has to fall by 16%,otherwise there would be an
excess supply of non-traded goods which would conflict with the internal balance
assumption.
The impact of the rise in the relative price of traded goods (p falls) on the CPI
depends on the Fed’s price stabilisation policy. If the Fed tries to stabilise the CPI
then with Y NT = 75% and Y T = 25% a 12% rise in traded prices would be
required and a 4% fall in non-traded prices. Since P T is set in world markets this
implies a 12% depreciation of the exchange rate.
The effects of current account changes depend crucially on the underlying
assumptions. For example,if the parameter θ equaled 0.5,instead of 1,this would
imply a nominal exchange rate depreciation of 24%. Alternatively,a value of
Y T /Y of 15% would imply a 20% exchange rate depreciation. If the assumption
of price flexibility is swapped for one of some price stickiness this will alter
the current account implications for the exchange rate further. For example,if
exporters only pass-through one-half of any exchange rate change to importers,
the Fed would have to let the dollar depreciate by 24% to stabilise the CPI and
the level of employment in the non-traded sector. With price stickiness of traded
and non-traded goods,and if imports account for about half of all traded goods
consumed,then a US dollar depreciation of between 40% and 50% would be
required.
The upshot of the Obstfeld and Rogoff analysis is that there is an important
short–long distinction in the effects of the current account on the exchange rate.
In the long run with price flexibility and a higher value of θ,the required exchange
rate change would be much smaller than the short-run where the combination of
price stickiness and a relatively small value of θ would produce a large exchange
rate change. Since their approach requires little in the way of data,the NOEM
approach would seem to offer a tractable way of calculating how much required
exchange rate adjustment is necessary to achieve current account objectives. It
therefore may be an appealing method of calculating equilibrium exchange rates
for developing countries or transition economies where data constraints may make
it difficult to implement some of the other approaches outlined in this chapter.