WORKING PAPER 08-6

Estimating Consistent Fundamental Equilibrium Exchange Rates

by William R. Cline, Peterson Institute for International Economics

This paper develops a new symmetric matrix inversion method for estimating consistent fundamental equilibrium exchange rates (FEERs) for leading advanced and emerging-market economies. It is symmetric in that it gives equal weight to the current account adjustment targets of all economies considered. The method involves first identifying desired changes in current account balances, then arriving at a set of parameters for the response of current account balances to real effective exchange rate changes. With the current account target and exchange rate response parameter in hand for each country (or region), it is possible to directly calculate the change in effective exchange rate needed to obtain the target change in current account. Matrix inversion is then used to identify a set of changes in bilateral exchange rates against the dollar that will generate a set of changes in multilateral (trade-weighted) effective exchange rates that is as close as possible to the targets desired.

The numerical estimates here draw on the International Monetary Fund's April 2008 World Economic Outlook forecasts of baseline current accounts and apply normative current account targets suggested in Policy Brief 08-7 by Cline and John Williamson as the basis for calculating the needed changes in exchange rates. The policy brief further discusses the grounds for identifying the target current account balances, adds two variants to the current account adjustment targets considered, and examines the policy implications of the results.

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RELATED LINKS

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Policy Brief 10-15: Estimates of Fundamental Equilibrium Exchange Rates, May 2010 June 2010

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Working Paper 08-2: Currency Undervaluation and Sovereign Wealth Funds: A New Role for the World Trade Organization January 2008

Policy Brief 07-8: The Case for Exchange Rate Flexibility in Oil-Exporting Economies November 2007

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Policy Brief 07-4: Global Imbalances: Time for Action March 2007

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