Estimating Consistent Fundamental Equilibrium Exchange Rates

Working Paper
08-6
July 2008

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.