Exchange Rate Economics: Theories and Evidence

250 Equilibrium exchange rates
Conclusions
In this chapter we have overviewed different ways of constructing an equilibrium
real exchange rate. These approaches all take as their starting point the view that,
for the reasons given in Chapter 2,PPP on its own is not sufficient for calculating
an equilibrium exchange rate. We argued that purchasing power parity and
atheoretical constructs are unlikely to be well-suited for this purpose. However,
we have also argued that there are a variety of approaches which do provide
well-defined measures of equilibrium. A strictly medium-run measure of the equilibrium
exchange rate is provided by the capital enhanced extension of PPP. This
approach has been demonstrated to produce mean reversion speeds that are much
faster than that produced by PPP on its own. The approach may also be extended
in a straightforward fashion to incorporate other financial effects such as the yield
gap and,say,stock market revaluations. More structured approaches to defining
the medium-run equilibrium exchange rate are provided by the different variants
of the internal–external balance approach. In this approach the key characteristic
of the medium-run is that any current account imbalance must be sustainable.
The internal–external balance approach also provides a measure of the long-run
exchange rate which is usually defined as a position where net foreign assets are
constant. One key feature of the internal–external balance approach is that it
usually contains a substantial normative element,in terms of what is meant by
sustainability and internal balance. The behavioural equilibrium approach seeks
to provide a measure of the equilibrium exchange rate which is stock-flow consistent
and which is independent of assumptions about sustainability. However,the
approach can be used to provide a measure of equilibrium in which fundamentals
are calibrate at sustainable levels,although this is quite a separate exercise. We
have also argued that further insight into the nature of a behavioural equilibrium
exchange rate may be gauged from a decomposition of the real exchange rate into
its permanent and transitory components.