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Estimates of the Fundamental Equilibrium Exchange Rate of Kuna Katja Gattin Turkalj Croatian National Bank Introduction Real Equilibrium Exchange Rates • A “fair” value of a currency • Getting the rate “right” is of great importance as the exchange rate influences competitiveness, price trends and other key macroeconomic variables. • Various concepts of EER, depending on the definition of internal and external balance FEER • Fundamental equilibrium exchange rate • FEER is the real effective er that secures internal and external balance for a country (or for a number of countries) simultaneously. • Internal balance: NAIRU • External balance: "sustainable" BoP position FEER • Advantages: does not require to much data, easily computed, and tested in the literature many times • Drawbacks: normative elements, ad hoc definition of sustainable CA position, difficult to model trade, but… • “Possibly the most popular of the underlying balance models” (Driver and Westaway, 2001) Trade, capital flows and ER in Croatia Index of Real Exchange Rate 116 112 108 104 100 96 92 94 95 96 97 98 99 00 01 IREET ppi 97 eop 02 03 04 7.8 10 7.6 9 7.4 8 7.2 7 7.0 6 6.8 5 6.6 4 94 95 96 97 HRK_EUR 98 99 00 HRK_USD 01 02 03 04 kuna/USD kuna/euro Nominal ER of Euro and USD PPI for Croatia, EU, and relative PPI 124 120 116 112 108 104 100 96 92 94 95 96 97 PPI97EUR 98 99 00 01 PPI97HRV 02 03 04 PPI97REL Construction on IREER WEIGHTS ECU/EUR USD GBP CHF SIT 70,6 27,2 1,0 1,0 0,2 Export of goods and services 32 in % of GDP 28 24 20 16 12 8 93 94 95 96 97 98 SHARE_EXPG_CP 99 00 01 02 03 04 SHARE_EXPS_CP Imports of goods and services -8 -9 -10 in % of GDP (goods) -36 -11 -40 -44 -48 -52 93 94 95 96 97 98 SHARE_IMPG_CP 99 00 01 02 03 04 SHARE_IMPS_CP in % of GDP (services) -7 Destination of exports in % of total exports TOTAL eu15 eu25 of which -Austria -Italy -Germany -Slovenia Bosnia and Herzegovina YU;Srbija and Montenegro Russia USA 2004 100 51 65 9 23 11 7 14 4 1 3 cum 2004 65 79 83 84 87 Changes in trade patterns • WTO 2000 • Bilateral agreements (first signed in 1996, by the end of 2004 25 agreements) • EFTA 2001 • SAA 2001 • CEFTA 2003 • Return of export markets of former YU Liberalization of capital flows • New FX law in 2003 • Liberalization especially for firms • Very few restrictions remain (some shortterm flows, outflow of capital for residents, real estate, …) to be lifted by the end of SAA (2007) Estimating FEER Concepts of equilibrium ER • market equilibrium: balances supply and demand of currency (Williamson) • current equilibrium: consistent with the given or current fundamentals • medium term equilibrium: consistent with • the fundamentals at their equilibrium level long term equilibrium: in the long run, the capital stock and foreign debt are also endogenous and will be related, along with the real exchange rate, to long run fundamentals Estimates of the EER • PPP, HBS and NATREX are long-term concepts, • On the short end, there are purely statistical approaches SVAR, BEER and CHEER • FEER, DEER and PEER, refer to modeling the medium term equilibrium. Estimating FEER • Internal eq: potential GDP growth associated with low and "non-accelerating" inflation rate • 1) Output gap • 2) HP filter or BN decomposition Estimating FEER • External eq: • 1) Macroeconomic balance approach (IMF) • S(X)-I(Y)=CA (rer, Ybar) • X and Y are arrays of explanatory variables (fiscal position, openness, population growth...) • 2) "sustainable" current account position... Estimate Trade balance • and elasticities of imports and exports relative to the exogenous variables ln( X ) 11 12 ln( Y * orM *) 13 ln( RER ) 1 ln( M ) 21 22 ln( Y ) 23 ln( RER ) 2 • • + + + - Solve for FEER • CA= X-M • FEER is the solution for RER in 21 22 ln(Y ) 23 ln(RER) 1112 ln(Y *)13 ln(RER) CA e e CA%Y Y Y • when CA, Y and Y* are replaced with their long term values Estimate X and M equations… DLOG(X) = -5.25 + 1.10*LOG(RER) + 3.44*DLOG(M*(-1)) + 4.58*DLOG(M) (-2.18) (2.12) (5.01) (12.16) R2=0.79 F-stat=53.9 DLOG(M) = 0.47 + 1.09*DLOG(Y) - 0.10*LOG(RER) (0.30) (4.18) (-0.29) R2=0.27 F-stat=8.54 4/04. 2/04. 4/03. 2/03. 4/02. 2/02. 4/01. 2/01. 4/00. 2/00. 4/99. 2/99. 4/98. 2/98. 4/97. 109 2/97. 111 4/96. 113 2/96. 4/95. 2/95. Actual REER and FEER 115 reer feer hpTB feer TB 0% feer TB -6,5% 107 105 103 101 99 97 95 Conclusion • The drawback inherent in the FEER method, cannot be resolved within the framework of FEER • Often, another method is used along with FEER to verify its findings (BEER)