Real Exchange Rates for the Year 2000 (Policy Analyses in International Economics)

This study discusses the fundamental equilibrium exchange rate (FEER) method of estimating an equilibrium real exchange rate, and it estimates FEERs for the Group of Seven countries (G7) for 1995 and 2000. It uses recent data and improved methodology to update previous estimates of equilibrium real exchange rates for the G7. Two developments motivate the need to provide up-to-date estimates of equilibrium exchange rates. First, foreign exchange markets continue to be volatile. There have been large swings in all G7 currencies in the last five years, and in these circumstances, the markets and policy-makers need some idea of the sustainable levels of these currencies. The second development is the prospect of European Monetary Union (EMU). Countries that enter EMU must do so at exchange rates that are close to equilibrium levels: if they do not, then they will eventually undertake costly deflation or inflation to bring their real exchange rate to its underlying level. The authors estimate equilibrium real exchange rates using a partial-equilibrium model based on econometric trade equations, assumptions of trend output, and estimates of the medium-run current account. They emphasize that the FEER is a medium-run construct and contrast it with the purchasing price parity (PPP) method of determining equilibrium real exchange rates. The authors discuss the links between the FEER and fiscal policy, and the extent to which the FEER is a normative concept, and conclude with sensitivity analysis for changes in current account and trend GDP assumptions.