The Fundamental Determinants of the Real Exchange Rate of the U. S. Dollar Relative to Other G-7 Currencies

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

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.