# Equilibrium Exchange Rate Theory

EquilibriumExchangeRateTheory Overview of Equilibrium Exchange Rate Theory About the concept of Forexrebatek cashback forexg Forex rebate king cashbackinforex, the British economist Gregory (T. E. Gregory) as early as 1934 had proposed Keynes in his 1935 article "The Future of Foreign Exchange" made a clear definition of equilibrium exchange rate. However, the earliest complete definition of the equilibrium exchange rate was given by the American economist RagnerNurkse in 1945, who defined the equilibrium exchange rate as the exchange rate at the time of simultaneous internal forexrebateindonesia external equilibrium in a balance-of-payments and full employment situation. However, the equilibrium exchange rate theory before the 1980s was only a qualitative theoretical analysis of the concept and meaning of the equilibrium exchange rate, and thus the theory of the equilibrium exchange rate during this period was not really taken seriously until the 1980s, when the theory of the equilibrium exchange rate was really developed due to the emergence of modern econometric theories such as time series and cointegration and their successful application to the equilibrium exchange rate model. Since the 1980s, equilibrium exchange rate research has evolved in three general directions: (1) research on equilibrium exchange rate theory itself, focusing on the connotation of equilibrium exchange rates and their economic significance; (2) research on equilibrium exchange rates in developed countries, where there is a large literature and relatively satisfactory results have been achieved; (3) research on equilibrium exchange rates in developing countries, where there is not much literature and the results are not very The main reason is that most developing countries are in transition and their economies are not very mature in themselves or in other aspects, so the conclusions of the studies are not of general significance The core of the equilibrium exchange rate theory is to analyze the impact of changes in basic economic factors on the equilibrium exchange rate and to estimate the equilibrium exchange rate by using the systematic linkage existing between them. The equilibrium exchange rate theories that have been studied systematically and achieved certain results can be broadly classified into four categories: the theory of equilibrium exchange rate of basic factors (FEER), the theory of equilibrium exchange rate of behavior (BEER), the theory of natural equilibrium exchange rate (NATREX) and the theory of equilibrium real exchange rate (ERER), which study the equilibrium exchange rate of developed or developing countries from different perspectives. Among them, the latter theory is mainly to study the equilibrium exchange rate problem in developing countries. Williamson first proposed in 1983 and began to use the theory of Fundamental Equilibrium Exchange Rates (FEER) to define the equilibrium exchange rate as the real effective exchange rate when it is consistent with macroeconomic equilibrium. The external equilibrium is characterized by the net flow of willing and sustainable capital between countries when they maintain internal equilibrium The FEER model is based on the macroeconomic equilibrium approach The core of the macroeconomic equilibrium approach is that the current account equals the capital account The FEER approach focuses attention on the determination of the current account In general, the current account can be typically interpreted as is a function of total domestic output (or aggregate demand), total foreign output (or aggregate demand) and the real effective exchange rate In many applications of the FEER approach, the medium-term capital account equilibrium can be estimated on the basis of relevant economic factors Thus, the real effective exchange rate can be derived from total domestic output (or aggregate demand), total foreign output (or aggregate demand) and the capital account The real effective exchange rate derived here is the one that corresponds to The exchange rate appropriate to macroeconomic equilibrium, what Williamson called the Fundamental Factor Equilibrium Exchange Rate (FEER) in 1983, shows that given the parameters of the current account model, especially under the condition that current account flows are sensitive to the real effective exchange rate, the FEER can be calculated using exogenous net sustainable capital flows It must be noted that the FEER is only a method of calculating the equilibrium exchange rate Since the calculation implicitly assumes that the real effective exchange rate converges gradually to the FEER, the theory of exchange rate determination embodied in the FEER approach is the theory of current account determination of the exchange rate. The above analysis clearly shows that the FEER calculation requires considerable parameter estimation and judgment, including (1) a current account model; (2) estimates of domestic and major trading partner countries The first two aspects have been the subject of more extensive theoretical and empirical analysis and are well defined conceptually and in terms of computational methods. However, the meaning and computational methods of the capital account are worth studying. (2) check whether the seemingly rational equilibrium is sustainable, and if not, the results must be reduced to make them sustainable; (3) check whether the resulting results are internationally coordinated, and if not, modify the over- or under-targeting for all countries until they are coordinated from an internationally consistent From the perspective of coordination, a general current account to GNP ratio of 1 to 2 percent is relatively reasonable. Williamson has extrapolated the target current account values for 1995 for 14 countries and regions based on factors such as investment demand determined by debt cycle factors and the effect of the age structure of the population on saving behavior, combined with sustainability and consistency judgments Bayoumi (1994). 1994), in measuring the equilibrium exchange rates of the major industrialized countries in 1970, assumes that the target current account is equal to the current account surplus of 1% of GDP This ratio is derived from the current account balance target for each country proposed by the United States during the Smithsonian Agreement consultations when discussing the appropriate ratio on the exchange rates of the major industrialized countries Of course, the subjectivity of the two approaches mentioned above is obvious In order to resolve To resolve this contradiction, Isard and Faruqee et al. (1998) consider the current account equilibrium as the difference between savings and investment required at full employment Savings and investment can be obtained as a function of variables such as the actual output and potential output gap and the fiscal deficit at full employment This approach does not essentially rely on subjective judgments because The FEER approach uses a special set of economic variables to calculate the exchange rate, which abstracts away short-term cyclical and temporary factors and concentrates on the fundamental factors of the economy, so that these fundamental factors are considered as variables that may have a medium-term role These variables do not have to necessarily occur in the future, and in fact it may just be an assumption of a will that never materializes In this sense, the FEER approach measures In fact, Williamson (1994) has characterized FEER as the equilibrium exchange rate when consistent with ideal economic conditions This normative approach in itself should not be criticized because it simply reflects the method of measuring exchange rates under a well-defined set of economic conditions Of course, one can choose different conditions to calculate the exchange rate From the above analysis, it is clear that the exchange rate estimated by the Second, deficit countries will accumulate external debt and, in order to maintain the current account balance, must depreciate the real exchange rate in order to increase trade revenues to compensate for the interest payments on the 13 increasing debt. Finally, if the level of income elasticity of import demand and the domestic growth rate, which exceed the level of income elasticity of export demand and the foreign growth rate, respectively, have adverse effects on the current account in the long run, this will also require a successive devaluation to eliminate such adverse effects even if they are equal, respectively, if the initial levels of imports and exports differ significantly The Fundamental Factor Equilibrium Exchange Rate (FEER) model abstracts from short-term cyclical and temporary factors and focuses on the impact of fundamental economic factors on the equilibrium exchange rate, revealing the nature of equilibrium exchange rate changes By focusing on the analysis of the current account, the model provides a concise and systematic approach to estimating the equilibrium exchange rate, providing a basis for policy makers to evaluate the exchange rate However, the The partial equilibrium approach of the FEER model also has obvious drawbacks: (1) the model implicitly makes two assumptions in its calculations: first, the approach assumes that the exogenous inputs to future output and capital accumulation are consistent in both directions; second, the approach implicitly assumes that these inputs are themselves independent of the actual exchange rate, in other words, it assumes that the model has a recursive structure so that asset accumulation and output can precede or be independent of The results of the exchange rate are obtained In practice, there are many reasons why the above assumption does not hold In terms of output supply, it depends on FEER because the real exchange rate affects real consumption income or asset costs In addition, when all industrial countries import a significant share of capital goods, the real exchange rate will also affect the cost of capital There is also a direct link between the real exchange rate and asset accumulation, but it is transmitted at the real interest rate (2 (3) The FEER model measures the equilibrium exchange rate when it is consistent with ideal economic conditions, but the estimates of potential output, capital account equilibrium, and capital account equilibrium in the home country and the relevant trading partner countries are not taken into account. (4) Although the model focuses on the impact of fundamental economic factors on the equilibrium exchange rate, in the actual analysis, due to the difficulties in data processing, how to filter out the short-term cyclical and temporary factors from the real data is still a problem that needs further solution. The Behavioral Equilibrium Exchange Rate Theory (BEER) was developed by Peter B. Clark and Ronald MacDonald. The main research results in this area have been published by Goldman Sachs (1997) in a booklet. In the previous analysis, we know that the FEER approach calculates the concept of equilibrium exchange rate when the current account is consistent with sustainable capital flows in a full employment situation. It is not clear, i.e., whether it reflects the effects of medium-term determinants of the exchange rate is not clear The BEER approach attempts to overcome this limitation by including a direct econometric analysis of the actual effective exchange rate behavior From a methodological point of view, the BEER approach is a modeling strategy that attempts to explain the actual behavior of the exchange rate conditional on the economic variables of interest, which is why Macdonald et al. refer to it as the behavioral equilibrium exchange rate The reason for this is that in the BEER approach, the relevant concept of equilibrium is given by an appropriate set of explanatory variables (generally estimated in their real values), unlike the FEER approach which uses macroeconomic equilibrium as the equilibrium concept associated with the evaluation of real exchange rates Therefore, the BEER approach is characterized by the embedding in the model of some variables that are systematically behaviorally linked between the exchange rate and its determinants The characteristic of the BEER approach is the use of a parsimonious model instead of FEER to estimate the equilibrium exchange rate The core of this parsimonious model is the interpretation of the real effective exchange rate as a function of a vector of economic fundamentals with long-run persistent effects, a vector of economic fundamentals affecting the real exchange rate in the medium term, a vector of temporary factors affecting the real exchange rate in the short term and a stochastic disturbance term Thus, in any period, the total exchange rate misalignment can be decomposed into short-term temporary The behavioral equilibrium exchange rate approach can be used both to measure the equilibrium exchange rate and, in principle, to explain the cyclical movements of the real exchange rate. In the actual econometric analysis, the long-term exchange rate model starts from a similar risk-adjusted interest rate parity condition, i.e., the real equilibrium exchange rate is composed of the expectations of the real exchange rate, the domestic and foreign real interest rate differentials, and the risk discount. The three components of the risk discount are determined assuming that the time difference in the risk discount is a function of the relative supply of domestic and foreign government debt, then a significant increase in the relative supply of domestic debt relative to foreign debt will increase the domestic risk discount and thus require the realistic equilibrium real exchange rate to depreciate introducing the long-run equilibrium exchange rate and assuming that it is equal to the expectations of the uncertain exchange rate According to the analysis of Clark and Macdonald (1998) The long-run equilibrium exchange rate is primarily a function of three variables: terms of trade, the Balassa-Samuelson effect, and net foreign assets Therefore, a combination of these analyses leads to the conclusion that the behavioral equilibrium exchange rate (BEER) is a parsimonious model as a function of the variables of domestic and foreign real interest rate differentials, relative domestic and foreign government debt supply, terms of trade, the Balassa-Samuelson effect, and net foreign assets Clark and McDonald (1998)~1] used the above-mentioned parsimonious model to empirically analyze the real effective exchange rates of the U.S. dollar, the Deutsche Mark, and the Japanese yen, and showed that the BEER approach has good explanatory power. The BEER approach does not directly consider the internal and external equilibrium, but theoretically, the values of the basic economic factors can be adjusted to full employment and low inflation, i.e., they can be adjusted to be consistent with the internal equilibrium. There are two reasons for this phenomenon: first, the model is based on the assumption of non-offsetting interest rate parity, so it is not possible to effectively limit the financing of external imbalances; second, the model embodies an adjustment mechanism that generates an equilibrium change in the real exchange rate that corresponds to the level of government debt and net foreign assets in order to achieve an equilibrium change in the real exchange rate. equilibrium changes in the real exchange rate to achieve external equilibrium, at least in the long run This is a shortcoming of the BEER approach However, since the BEER approach includes a direct econometric analysis of the behavior of the real effective exchange rate, it attempts to explain the actual behavior of the exchange rate conditional on the relevant economic variables and thus provides better computational and explanatory examples From the results of the empirical analysis, the BEER The natural equilibrium exchange rate theory The natural equilibrium exchange rate theory (in full NaturalRealExchangeRates, abbreviated as NATREX) was proposed by Jerome L. Stein in 1994 Its basic meaning is that, without taking into account cyclical factors, speculative capital flows, and international reserve movements, the exchange rate determined by The theory is mainly an empirical explanation of the movement of the real exchange rate in the medium to long run, given the real variables of the fundamentals such as thrift and productivity. The basic assumptions of the natural equilibrium exchange rate model are: prices clear the market and output has reached its intrinsic potential level at that point; the real exchange rate is adjusted to the real equilibrium level Under these assumptions, the natural equilibrium exchange rate model can be expressed by an equation similar to that of the national income account, i.e., the difference between savings and investment equals the current account balance. As can be seen, the core elements of the natural equilibrium exchange rate model are reflected in investment, savings, and net capital flows (i.e., the difference between savings and investment) In the case of highly mobile capital, when a depreciation in the real exchange rate and an increase in net inward capital flows (i.e., the difference between investment and savings) lead to changes in the real stock of physical capital, wealth (i.e., the difference between the real stock of physical capital and net external debt), and net external debt, respectively, these stock Changes in these stocks in turn change the required investment, savings, and current account balances, thus requiring a new equilibrium exchange rate level The natural equilibrium exchange rate can remain constant only when the economy reaches a long-run equilibrium, i.e., when the basic economic factors and the real stock of assets remain constant Exogenous basic economic factors, such as the degree of domestic and foreign thrift and productivity (and, for small countries, exogenous terms of trade and changes in the international real interest rate) affect the natural equilibrium exchange rate in two ways: (1) first by affecting the required investment, savings, and current account, thereby inducing corresponding changes in the natural equilibrium exchange rate in the medium term; (2) by changing the trajectory of the natural equilibrium exchange rate to the new long-run equilibrium level through changes in the real stock of physical capital, wealth, and the rate of accumulation of net foreign debt as long as it is not at the long-run equilibrium level A complete model of the natural equilibrium exchange rate can determine the medium-term real equilibrium exchange rate (i.e., the natural equilibrium exchange rate), the trajectory of the natural equilibrium exchange rate, and the long-run equilibrium exchange rate (i.e., the steady-state equilibrium exchange rate which is simply a function of the exogenous real basic economic factors) The basic ideas of the theory are that (1) (2) the natural equilibrium exchange rate is a moving equilibrium real exchange rate that is consistent with continuous changes in exogenous and endogenous economic fundamentals, and the real exchange rate constantly moderates the moving equilibrium real exchange rate; (3) the impact of foreign debt borrowing on the The long-term impact of natural equilibrium exchange rate depends on whether the borrowed foreign debt is used for consumption or net investment; if the borrowed foreign debt is used for consumption then the real exchange rate will result from appreciation to gradual depreciation, if the borrowed foreign debt is used for productive investment then the real exchange rate will result from appreciation to gradual depreciation to appreciation (if the country becomes a net creditor); (4) The most effective way to improve the current account is to change the The NATREX approach is a family of models that rely on the following characteristics: the economic size of tradable goods and assets relative to those of trading partners, the elasticity of supply and demand for foreign goods and assets, and substitutability among goods, assets, countries, and within countries. Based on these characteristics, the NATREX models can be subdivided into two categories: asset market-based and money market-based. The core of the NATREX model is a family of general equilibrium exchange rate models in which rational and optimal behavior determines the equilibrium real exchange rate, and these models provide a more logical economic judgment for empirical studies Before the NATREX approach was proposed, the general theory of exchange rate determination was rarely successful in explaining fluctuations in the nominal exchange rate, and in particular, it could not explain the 1980s dollar The NATREX model has better explanatory power for the appreciation and then depreciation of the nominal and real exchange rates Stan examined the exchange rates of the United States and the G-10 countries and their changes were consistent with the changes in the underlying economic factors and the forecasts made were well in line with reality Lin (GuayLin) and Stan studied Australia, a relatively small country, and the actual underlying factors also explained the real exchange rate better LilianeCmuhy-Veyrac and MicheleSaintMarc study medium-sized economies like Germany and France, which are not able to influence international interest rates, but can influence trade prices and trade structure The results demonstrate that real effective exchange rates change in line with changes in the fundamentals, but their regulation is relatively slower than under floating exchange rate conditions Finally, it is also important to note that NATREX is an empirical rather than a normative concept that deals with exchange rates determined by real fundamentals on the basis of existing economic policies and does not involve social welfare issues This is where the NATREX differs from the FEER concept in In the FEER model, the real equilibrium exchange rate is the exchange rate when the current account measured by potential output is consistent with the desired capital flow, where the desired capital flow is not distorted by public policy. In addition, the NATREX model has the characteristics required to take into account the stock equilibrium conditions, which is what makes it different from the FEER model. According to Edwards (1989) definition, the equilibrium real exchange rate (ERER) is the relative price of non-traded and traded goods if other relevant variables (e.g., taxes, international terms of trade, commercial policies, capital flows, etc.) are taken into account. If the values of other relevant variables (such as taxes, terms of trade, commercial policies, capital flows, and technology) are sustainable, then simultaneous internal and external equilibrium will be achieved when the market for nontradables clears now and in the future, internal equilibrium, and external equilibrium when real and future current account balances are consistent with long-term sustainable capital flows. Iobadawi (1992) argues that a successful ERER model should include at least three elements: (1) it should develop ERER as a long-run function of the fundamentals; (2) it should allow for flexible and dynamic adjustment of the PER (real exchange rate) to ERER; (3) it should allow for short- and medium-term macroeconomic and exchange rate policies to have an impact on ERER have an impact on ERER The ERER model originated from the Seot-Swan model of non-tradable goods (Salter-Swan), which is a model of a small or dependent economy such that countries are too small to influence their own terms of trade (Salter, 1959; Swan, 1960) Williamson ( Williamson has referred to ERER as the "Chicago" definition, so the ERER model is mainly for developing countries equilibrium exchange rate problems. Since developing countries economies are characterized by exchange controls, trade barriers, and parallel exchange rates, Edwards makes the following assumptions about the model: (1) ) An open economy small country is considered, with three categories of goods in its market: exports, imports, and nontradables, with the country producing exports and nontradables and consuming imports and nontradables; (2) A dual exchange rate exists, with a fixed nominal exchange rate for commodity transactions and a free floating nominal exchange rate for financial transactions; (3) The countrys residents hold both local and foreign currency, and the private sector accumulates a amount of foreign currency; (4) government revenue is generated from non-distorting taxes and domestic credit creation, and the government consumes imports and non-traded goods; (5) government and private individuals cannot borrow externally, and there is no domestic public debt; (6) there are import tariffs, and tariff revenues are passed back to the public in a non-distorting manner; (7) export prices expressed in foreign currency are fixed and equal to unit 1; (8) it is initially assumed that There are effective capital controls such that there are no international capital flows, and later the assumption is relaxed that the government is not inclined to capital controls and there are capital flows in and out of the country; (9) There are perfect expectations Under the above assumptions, Edwards constructs a 16-equation equation with five components including asset determination, demand sector, supply sector, government sector, and external sector When the market for nontradables clears, the external sector achieves equilibrium (i.e., international The economy is in a steady state when the four conditions of market clearing for nontradables, equilibrium in the external sector (i.e., changes in international reserves, the current account balance, and changes in the money stock are each equal and equal to zero), sustainability of fiscal policy (i.e., government spending equals undistorted tax revenues), and equilibrium in the asset portfolio hold simultaneously, at which point the exchange rate reaches a long-run sustainable equilibrium Using these conditions and the constructed equations, a model of the long-run equilibrium real exchange rate can be derived Based on the derived model, Edwards finds that the long-run equilibrium real exchange rate is a function of such fundamental economic factors as terms of trade, capital flows, tariff levels, labor productivity, and government consumption In the short run, changes in monetary variables, etc., will also affect changes in the real exchange rate Edwards (1989) specifically analyzes the effects of real disturbances on the equilibrium real exchange rate: (1) Terms of Trade and the Equilibrium Real Exchange Rate In general, an improvement in the terms of trade will have both recipient and substitution effects. Other things being equal, generally speaking, an improvement in the terms of trade will lead to an appreciation of the equilibrium real exchange rate, and a deterioration in the terms of trade will lead to a depreciation of the equilibrium real exchange rate. Other things being equal, if the Marshall-Lerner condition holds, then a reduction in tariffs will lead to a depreciation of the equilibrium real exchange rate, but the results on the equilibrium real exchange rate will be different depending on the type of tariff reduction. (3) Foreign capital flows and the equilibrium real exchange rate In general, in the short run, foreign capital flows will lead to an appreciation of the equilibrium real exchange rate In the long run, if foreign capital flows in the form of debt and all of it goes into the consumption sector without creating any productivity, it will lead to a depreciation of the equilibrium real exchange rate; if it goes into the investment sector, it will lead to a depreciation of the equilibrium real exchange rate. sector, it will lead to equilibrium real exchange rate appreciation if foreign capital flows in the form of industrial investment, especially in the outward-oriented sector, it will lead to equilibrium real exchange rate appreciation (4) Technological progress and equilibrium real exchange rate Due to the Balassa-SamuelsonsEfect ), the rate of technological progress in the traded sector is relatively faster than in the non-traded sector, so the relative prices of traded and non-traded goods will gradually decrease over time, and thus technological progress will lead to an appreciation of the equilibrium real exchange rate under normal circumstances On the basis of the long-run equilibrium real exchange rate model, Edwards (1994) also constructs a structural dynamics equation for the change in the movement of the real exchange rate The structural dynamics equation The structural dynamics equation shows that the movement of the real exchange rate is influenced by four main forces: first, the automatic adjustment mechanism of the exchange rate, which is the gradual adjustment of the real exchange rate to the equilibrium real exchange rate, other things being equal; second, the adjustment mechanism of policy, which is the gradual adjustment of macroeconomic policies such as monetary and fiscal policies to their sustainable levels; third, the lagged adjustment mechanism of the nominal exchange rate, which actually reflects the nominal depreciation rate; fourth, the lagged adjustment mechanism of the nominal exchange rate, which is the gradual adjustment of the real exchange rate to the equilibrium real exchange rate. the nominal depreciation rate; and fourth, the adjustment mechanism of gradual reduction of exchange rate differences between different foreign exchange markets that exist simultaneously Since the equilibrium real exchange rate is mainly influenced by basic economic factors such as terms of trade, capital flows, tariff levels, labor productivity and government consumption, it can be concluded that the movement of the real exchange rate is a function of the terms of trade, the ratio of non-traded goods consumed by the government to gross domestic product (GDP), tariff level, technological progress, capital flows, and the ratio of investment to GDP, among other variables Edwards verifies the most important implication of the model using data for 12 developing countries: (1) in the short run, real exchange rate movements are a reflection of both real and monetary disturbances; (2) in the long run, equilibrium real exchange rate movements depend only on real variables; (3) in the short run, discontinuous expansionary macroeconomic policies will lead to real exchange rate misalignment (overvaluation); (4) if nominal exchange rate depreciation is accompanied by a thousand real exchange rate misalignment cases and appropriate macroeconomic policies, then nominal exchange rate depreciation will have a persistent effect on the equilibrium real exchange rate The results of the empirical analysis better support the models implication In addition, Iobadawi constructs an ERER model with long-term In addition, Iobadawi constructs an ERER model with long-term expectations based on the Edwards model and conducts an empirical analysis using data from Chile, Ghana, and India, which yields more reasonable results than the Edwards model. The ERER model takes into account the characteristics of developing countries transition economies and is therefore more suitable for measuring equilibrium exchange rates and evaluating real exchange rates in developing countries. In addition, the equilibrium real exchange rate derived from the model is not directly observable, so it is worthwhile to study how to measure its accuracy. The research on the theory of RMB equilibrium exchange rate is mainly based on the Western equilibrium exchange rate theory, and then the original model is improved by choosing different explanatory variables according to the actual situation in China. Although domestic scholars have attempted to measure the RMB equilibrium exchange rate by using different variables to explain the changes in the RMB real exchange rate, and have indeed made some progress, it can be seen that the theoretical framework used does not go beyond the scope of several equilibrium exchange rate theories introduced above, which in a way In a sense, it also shows that there is an urgent need for China to develop an equilibrium exchange rate theory that suits the reality of our country, and this is the direction of our future efforts equilibrium price strategy

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