## The Fundamental Determinants of the Real Exchange Rate of the U. S. Dollar Relative to Other G-7 CurrenciesWP/95/81-EA The Fundamental Determinants of the Real Exchange Rate of the U.S. Dollar Relative to Other G-7 Currencies by Jerome L. Stein This paper provides a consistent theoretical framework to explain the evolution from the medium to the longer run of the equilibrium real effective exchange rate of the U.S. dollar relative to the currencies of the other major industrial countries. The equilibrium exchange rate abstracts from the effects of speculative capital flows and changes in reserves and requires both internal and external balance. Internal balance means that the rate of capacity utilization is at its stationary mean value. External balance requires convergence of real long-term rates of interest. The fundamental determinants of the equilibrium real exchange rate, called the Natural Real Exchange Rate (NATREX), are productivity and time preference (an inverse measure of thrift) in the United States and the other major industrial countries. Time preference is measured by the ratio of the sum of private and public consumption to GNP. Productivity, which reflects the q-ratio, is measured by the growth rate. The paper explains theoretically how rises in either the rate of time preference or the q-ratio appreciate the real exchange rate in the medium run. In the longer run, an increase in time preference raises the foreign debt and depreciates the real exchange rate below its initial level. The long-run effect of a rise in the q-ratio is ambiguous. It eventually leads to a lower debt, which tends to appreciate the exchange rate; however, it also raises capital and output, thereby increasing imports and depreciating the exchange rate. The theoretical model can be shown to correspond to an estimating equation for the real exchange rate with three parts. The cointegrating part is the longer-run effect. This part plus the error correction component reflect the moving equilibrium. The third part is the disequilibrium component when there is neither internal nor external balance. Nonlinear least squares are used to estimate the equation explaining the real exchange rate. This estimated equation serves two purposes. First, it shows that the model has explanatory power. Second, when the disequilibrium components are set equal to zero--which serves as the calibration method--the result is an estimate of the equilibrium real exchange rate. Comparing the actual with the estimated equilibrium real exchange rate yields a measure of the degree of misalignment. Moreover, the causes of the misalignment are shown. Finally, the NATREX is compared with the FEER/DEER concepts of equilibrium exchange rates. |