Peter Isard, Hamid Faruqee, G. Russell Kincaid, and Martin Fetherston
©2001 International Monetary Fund
Surveillance over the exchange rate policies of its member countries is a central responsibility of the International Monetary Fund. In late 1994, the IMF staff took a step toward making its surveillance more effective by initiating more extensive and systematic assessments of the current account positions and exchange rates of the major industrial countries, incorporating both the perspectives of the IMF's area departments and calculations derived from a multilateral framework implemented by the IMF Research Department. In 1995, an interdepartmental working group, the Coordinating Group on Exchange Rate Issues (CGER), was established to strengthen and extend this work, and to provide a greater degree of discipline and consistency in the staff's judgments about exchange rates. CGER's general approach for assessing the current accounts and exchange rates of the major industrial countries was reviewed by the IMF's Executive Board in October 1997, and a description of the methodology was subsequently made public.1
This paper reports further on CGER's work, as reviewed by the IMF's Executive Board in June 2001. It provides perspectives on alternative frameworks for assessing exchange rates and the rationale for CGER's general approach (Section II and Appendix I); it updates the description of the methodology for assessing the current accounts and exchange rates of industrial countries, pointing to the relative strengths and weaknesses of CGER's analytic framework and the judgments involved in deriving and interpreting the quantitative assessments (Section II and Appendixes II and III); it describes some initial efforts to develop a separate methodology for assessing the current account positions of emerging market economies (Section III and Appendix IV); and it concludes with a brief summary (Section IV). The focus of this paper is on methodology and interpretive issues, rather than on numerical assessments.
CGER's work on industrial countries is motivated by the wide fluctuations that have occurred in exchange rates among major currencies during recent decades. As illustrated by Figure 1, both the nominal and real effective (weighted-average) exchange rates of major currencies have frequently exhibited prolonged movements in one direction followed by pronounced reversals. One case in point is the dramatic rise of the U.S. dollar during the first half of the 1980s, followed by an equally large drop between early 1985 and early 1987. The Japanese yen and the pound sterling have also been pushed to sharply appreciated and depreciated levels a number of times over the past two decades, and similar wide variation is evident for weighted-average exchange rates of the deutsche mark against the currencies of countries outside the euro area.
Economists have achieved reasonable success in developing an understanding of the relationships between exchange rates and macroeconomic fundamentals over the medium run and, hence, of the trends in exchange rates over time. In particular, trends in nominal exchange rates tend to reflect inflation differentials over the medium run, and real exchange rates tend to gravitate toward levels at which the associated current account imbalances are fairly moderate in size and consistent with factors that influence the relative saving and investment positions of different countries over the medium run. It has also been demonstrated formally that the short-run behavior of exchange rates includes a large unpredictable component. Although a consensus has emerged on partial explanations for some of the large deviations of currency values from their medium-run trends, such as the impact of the shift in the U.S. policy mix in pushing the dollar higher in 198082, for the most part changes in macroeconomic fundamentals have not provided convincing and generally accepted explanations for the wide swings in exchange rates. This has contributed to the view that market exchange rates sometimes become substantially misaligned with medium-run macroeconomic fundamentals.
Wide swings in real exchange rates have major effects on countries' competitiveness, which can have significant implications for the growth and composition of economic activity and employment.2 Moreover, the potential for substantial nominal and real effects of large exchange rate changes complicates the task of monetary policy, sometimes adding significantly to the difficulties of keeping economies expanding at close to full potential and with low inflation. Accordingly, the behavior of exchange rates is a relevant concern for policymakers. In making policy decisions, it can be important to assess by how much prevailing exchange rates deviate from the levels that are consistent with medium-run fundamentals--or, equivalently, the levels toward which exchange rates seem likely to gravitate over time.
In providing guidance to IMF staff, the Executive Board has stressed that the IMF's views on possible misalignments should be communicated in a timely and confidential manner to the authorities concerned. In light of the considerable difficulties in estimating equilibrium exchange rates, the IMF has generally not taken a public posture on exchange rate misalignments. On a number of occasions, however, CGER's assessments have provided a basis for the staff and management to express qualitative judgments about exchange rates among the major currencies, both in the context of the World Economic Outlook (WEO) and in meetings of the Group of Seven and other international fora. The assessments have also been employed by the IMF's area departments in their dialogues with national authorities during Article IV consultations with industrial countries, and in some cases the assessments for individual countries have appeared in published staff reports. CGER revisits its assessments semiannually in association with the updating of the WEO projections.
1Isard and Faruqee (1998).
2In addition, sharp currency appreciations often give rise to political pressures to protect exchange-rate-sensitive sectors of the economy from foreign competition.