Workshop on equilibrium real exchange rate modelling: Key insights and approaches from around the world
A prestigious international workshop on equilibrium real exchange rate (ERER) modelling was held at the Czech National Bank in Prague on 28 and 29 November 2024. This unique two-day event, attended by top economists from central banks and the European Commission, provided a platform for sharing the latest knowledge, empirical methods and approaches to modelling the equilibrium exchange rate. The workshop programme was divided into thematic blocks, which included detailed presentations of the ERER models used at individual central banks and broader views on global economic factors affecting the ERER. CNB Bank Board member Jan Kubíček delivered the keynote speech on the first day. The ERER modelling approaches of the central banks of the Visegrad Four countries (the Czech Republic, Slovakia, Hungary and Poland) were then discussed. This was followed by presentations by experts from the central banks of Croatia, Norway, Switzerland and Iceland and by a presentation of the European Commission’s modelling toolkit. The second day included contributions from non-European central banks, with presentations given by experts from Canada, Mexico, Chile, Colombia, Uruguay, South Africa and South Korea.[1]
Motivation
The equilibrium real exchange rate (ERER) is an important indicator for ensuring macroeconomic stability and the effective conduct of monetary policy in economic theory and practice. One of the main reasons for modelling the equilibrium exchange rate is its role as part of the real monetary conditions (RMCI). Equilibrium exchange rates enable central banks to analyse the effect of the exchange rate on inflation, GDP growth and the output gap. This is crucial for managing monetary policy in the short and medium term. This indicator helps identify potential fundamental imbalances that could threaten macroeconomic stability and long-term sustainability. It is an important contributor to determining the optimum exchange rate for integration into international monetary mechanisms, for example when preparing for euro area entry. The equilibrium exchange rate is also important for euro candidate countries for determining the central rate upon ERM II entry, which in the past ultimately became the conversion rate in countries joining the euro area (with the exception of Slovakia). Equilibrium rates also play an important role in assessing the price competitiveness of countries, especially strongly export-oriented ones. The normative dimension of equilibrium exchange rate estimates is often discussed in negotiations with international institutions such as the International Monetary Fund, where its estimated values are linked mainly to current account sustainability. Such estimates can also help provide arguments for potential central bank interventions in the foreign exchange market. Modelling of equilibrium exchange rates is therefore a very useful tool for assessing the effective conduct of monetary policy and the price competitiveness of the economy.
Approaches to estimating the equilibrium real exchange rate
The presentations given by the participating central bankers and representatives of international institutions revealed that several traditional approaches are used in practical modelling of the equilibrium real exchange rate. They differ in both methodology and objectives and are tailored to the specific circumstances of each economy. The approaches vary across institutions in how the real exchange rate (RER) is computed in terms of the price index used (see Chart 1), and in whether the RER is estimated in bilateral (against a single selected currency) or effective terms (against a basket of selected currencies, with weights based on countries’ importance in the home country’s international trade). A survey of the workshop participants revealed that the indices used most frequently to calculate the RER and the ERER are the CPI (nine institutions) and the PPI (eight institutions).
Chart 1 – Price indices used by individual institutions to calculate the RER and their number
Source: CNB
The model-based approaches to estimating the ERER consist of simple statistical models, behavioural and fundamental models, and comprehensive macroeconomic models. Chart 2 shows that the most frequently used approach is the BEER model, which is used by 14 of the 16 participating institutions. Seven institutions use only one model.
Chart 2 – ERER models used by individual institutions and their number in a single
Source: CNB
- Behavioural equilibrium exchange rate (BEER)
BEER models are relatively flexible and suitable for estimating the real equilibrium exchange rate in the short to medium term. They are based on analysing relevant economic fundamentals and use econometric techniques to estimate the long-term equilibrium real exchange rate. The following fundamentals used by the participating institutions in the specification of their BEER models were discussed. They are ranked by frequency from the most to the least used (see Chart 3). The BEER is often employed as a more flexible approach to estimating the equilibrium exchange rate, as it does not require the fulfilment of an equilibrium condition such as current account sustainability.
Chart 3 – Economic fundamentals used by individual institutions in the BEER model
Source: CNB
- Fundamental equilibrium exchange rate (FEER)
FEER models focus on analysing an exchange rate predicated on the simultaneous achievement of internal and external equilibrium of the economy, as proposed by Williamson (1994). Internal equilibrium is attained when actual GDP aligns with equilibrium (potential) GDP, that is, when the economy is neither overheating nor cooling. External equilibrium corresponds to current account sustainability. The FEER links the trade balance with macroeconomic fundamentals and is often used to assess competitiveness and set optimal exchange rates for monetary policy. The participants also discussed possibly extending the FEER model to take into account complex trade links in global value chains and thus provide a more detailed and accurate view of real exchange rates and their relationship to the equilibrium level in the context of economic integration in the global economic environment.
- Models based on purchasing power parity (PPP)
The PPP-based equilibrium exchange rate is such that a basket of goods and services should cost the same in different countries when converted at this exchange rate. PPP calculations assume that the real exchange rate stabilises in the long run at a level derived from the differences in price levels between countries. This assumption provides an intuitive basis for estimating the long-term equilibrium exchange rate. However, it is often criticised for being unrealistic, as it does not take into account structural changes in the economy or short-term shocks such as changes in productivity or the external balance of the economy. Some countries therefore combine PPP with other methods to compensate for these weaknesses and obtain more accurate ERER estimates.
- NATREX (Natural Real Exchange Rate)
The NATREX model tries to find the exchange rate consistent with equilibrium between domestic saving and investment, while reflecting changes in the current account (see Stein, 1994). The NATREX includes several behavioural equations for key macroeconomic variables such as investment, consumption, exports, imports and the real interest rate. This approach represents the medium- to long-term real equilibrium exchange rate that reflects economic fundamentals and eliminates cyclical factors and speculative capital flows. It is therefore best suited to advanced market economies with a relatively predictable and balanced structure and low short-term volatility of capital flows. By contrast, it is less appropriate for small open economies with high exposure to external shocks, strong short-term speculative capital flows and low foreign trade diversification. This is confirmed by the experience of several of the participating central banks trying to implement this approach.
- Others
In some countries, dynamic stochastic general equilibrium (DSGE) models are used to estimate the ERER, even though this is not their primary purpose. DSGE models allow for simultaneous estimates of different equilibrium values, including the ERER, and ensure consistency between the estimates. They are based on microeconomic foundations and allow us to simulate the effects of various shocks and policies on an economy in general equilibrium. Some economies use models based on analysing structural shocks such as monetary or growth shocks or shocks caused by an increase in perceived risk. These models take into account asymmetric responses of the exchange rate to different types of shocks and can be useful in an environment of high financial market volatility. In countries strongly dependent on commodity exports, ERER modelling is adjusted to the effects of commodity prices and external shocks. These economies often face large swings in the trade balance. This requires specific models that take into account the volatility of commodity prices and their impact on the exchange rate. The presented approaches to estimating the ERER also included the MIP approach (see Becker, Erhart and Saisana, 2018) – a tool used to detect potential macroeconomic risks associated with real exchange rates – and the IMF CA and IMF EBA-LITE models developed by the International Monetary Fund to estimate the equilibrium real exchange rate based on current account sustainability.
Summary
The presentations given by the participating central bankers and representatives of international institutions revealed that each of the above ERER modelling approaches has its advantages and limitations, with the choice of methodology depending on the specific characteristics of the economy and the purpose of the analysis. In practice, therefore, a combination of different estimation methods (including alternative econometric approaches) is often used to achieve as objective and robust equilibrium exchange rate estimates as possible. In addition, it was observed that European countries more frequently estimate their currency’s bilateral exchange rate against the euro. The vast majority of countries outside Europe estimate effective exchange rates. The exchange of experience between the workshop participants showed that the use of the consumer price index usually signals slightly greater exchange rate misalignment than when the producer price index is used. Interesting discussions related to foreign direct investment, which may have different effects on equilibrium exchange rate estimates at different times due to the changing phases of its life cycle. The participants also agreed that modelling the equilibrium exchange rates of the main reserve currencies is a much more challenging task. The benefits of equilibrium exchange rate estimates were also valued by representatives of central banks that actively use foreign exchange interventions to steer the exchange rate, whatever their reasons for doing so. Overall, the workshop highlighted the interdisciplinary nature of exchange rate research, which combines macroeconomic theory, empirical modelling and real monetary policy implications. The aim of the meeting of economists from around the world at the CNB was not only to share practical experience and knowledge, but also to discuss future lines of research in this area and their potential impact on the monetary policies of individual countries. The event not only contributed to a deeper understanding of exchange rate dynamics and the impact of exchange rates on the stability and competitiveness of the economy, but also fostered cooperation between exchange rate experts from central banks around the world and created a platform for future research and innovation in this area.
References
BECKER, W., ERHART, S., SAISANA, M. (2018): The Macroeconomic Imbalance Procedure. European Commission.
STEIN, J. (1994): The Natural Real Exchange Rate of the US dollar and Determinants of Capital Flows. In: WILLIAMSON, J. (ed.). Estimating Equilibrium Exchange Rates. Washington: Institute for International Economics.
WILLIAMSON, J. (1994): Estimates of FEERs. In: WILLIAMSON, J. (ed.). Estimating Equilibrium Exchange Rates. Washington: Institute for International Economics.
[1] The issue of modelling equilibrium exchange rates was also discussed with economists from the central banks of Australia, New Zealand, Brazil, and Sweden, as well as from the International Monetary Fund.