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WP/07/296 Equilibrium Exchange Rates: Assessment Methodologies Peter Isard © 2007 International Monetary Fund WP/07/296 IMF Working Paper IMF Institute Equilibrium Exchange Rates: Assessment Methodologies Prepared by Peter Isard 1 December 2007 Abstract This Working Paper should not be reported as representing the views of the IMF. The views expressed herein are those of the author(s) and should not be attributted to the IMF, its Ex
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  WP/07/ 296   Equilibrium Exchange Rates: Assessment Methodologies  Peter Isard       © 2007 International Monetary Fund WP/07/ 29 6   IMF Working Paper IMF Institute Equilibrium Exchange Rates: Assessment Methodologies Prepared by Peter Isard 1   December 2007 Abstract This Working Paper should not be reported as representing the views of the IMF.   The views expressed herein are those of the author(s) and should not be attributted to the IMF, its Executive Board, ot its management. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.   The paper describes six different methodologies that have been used to assess the equilibrium values of exchange rates and discusses their limitations. It applies several of the approaches to data for the United States as of 2006, illustrates that different approaches sometimes provide substantially different assessments, and asks which methodologies deserve the most weight in such situations. It argues that while it is generally desirable to consider the implications of several different approaches, since different approaches provide different types of perspectives, two of the methodologies seem  particularly relevant for identifying threats to macroeconomic stability and growth. JEL Classification Numbers: F3, F31 Keywords: Equilibrium exchange rates Author  ’ s E-Mail Address:  pisard@imf.org  1  I am grateful for helpful comments from Gian Maria Milesi-Ferretti, Jaewoo Lee, Jonathan Ostry, Russell Kincaid, Carlo Cottarelli, and Tam Bayoumi. It should not be assumed that they completely agree with the views expressed in this paper.   2 Contents Page I. Introduction............................................................................................................................3 II. The Purchasing Power Parity Approach...............................................................................5 III. PPP Adjusted for the Balassa-Samuelson and Penn Effects..............................................10 IV. The Macroeconomic Balance Framework.........................................................................14 V. Assessments of the Competitiveness of the Tradable Goods Sector..................................19 VI. Assessments Based on Estimated Exchange Rate Equations............................................19 VII. Assessments Based on General Equilibrium Models.......................................................21 VIII. Case Study: The United States........................................................................................22 IX. Which Assessment Methodologies Deserve the Most Weight?........................................31 X. Conclusions.........................................................................................................................34 Boxes Box 1. The Purchasing Power Parity Hypothesis......................................................................6 Box 2. PPP and the Balassa-Samuelson Hypothesis...............................................................11 Box 3. A Simple Model of the Underlying Current Account Balance....................................17 Figures Figure 1. Exchange Rate Changes Versus Inflation Differentials Over Different Time...........7 Intervals Figure 2. Real Exchange Rates Between the United Kingdom and Germany, 1970-2000.......9 Figure 3. Cross-Section Evidence on the Relationship Between ICP Measure of Real..........13 Exchange Rates and GDP Per Worker Figure 4. Medium-Run Fundamentals ..........................................................................15 Figure 5. Real Effective Exchange Rates: United States, 1980-2006......................................24 Figure 6. Unit Labor Cost and the Implicit Price Deflator for the U.S....................................25  Nonfinancial Corporate Sector, 1995 Q1 – 2006 Q4 Figure 7. After-Tax Profits per Dollar of Sales in U.S. Manufacturing,.................................26 1995Q1 – 2006Q4 Figure 8. U.S. Goods Exports as Percent of GDP, 1995Q1-2006Q4......................................27 Figure 9. U.S. Current Account Balance as a Percent of GDP, 1970-2006.............................29 Figure 10. U.S. Net Foreign Assets as Ratio to GDP, 1980-2006...........................................30 Appendix I. Assessing the Sustainability of the Net Foreign Liability Position.....................37 Appendix II. An Estimate of the U.S. Underlying Current Account Position in 2006............39 References ..........................................................................................................................43
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