## IOverview

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**Canonical URL:** [IOverview](https://www.imf.org/-/media/websites/imf/imported-publications/external/pubs/nft/op/261/_op261.pdf)

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### Purpose and scope
- Exchange rate surveillance is at the core of the IMF’s responsibilities and the Fund has continuously adapted its framework for assessing exchange rates to underlying macroeconomic and financial developments.
- Since the mid-1990s the IMF Consultative Group on Exchange Rate Issues (CGER) has provided multilateral exchange rate assessments for a number of advanced economies to inform country-specific analysis in Article IV staff reports and foster multilateral consistency.
- The paper extends CGER-style assessments to cover emerging market countries in addition to advanced countries, focusing on methodological issues to underpin exchange rate assessments rather than on country assessments themselves.
- Key empirical orientation: exchange rate assessments are ideally based on the notion of equilibrium—consistency with external and internal balance over the medium to long run—but most empirical studies use reduced-form relationships relating the real exchange rate or trade flows to observed determinants.

### Context: integration and magnitude of change
- Over the past 15 years world trade and international financial integration have grown very rapidly:
  - the ratio of world trade to world GDP increased by over 40 percent;
  - the ratio of international financial cross-holdings to world GDP more than doubled.
- Emerging market countries increased their share of world trade from 27 percent in 1990 to 40 percent in 2006 and have become important in international capital flows.

### The three complementary methodologies
- The paper presents three complementary methodologies for exchange rate assessment:
  1. Macroeconomic balance (MB) approach
     - Calculates the difference between the current account balance projected over the medium term at prevailing exchange rates and an estimated equilibrium current account balance, or “CA norm.”
     - The exchange rate adjustment that would eliminate this difference over the medium term is obtained using country-specific estimated responses of the trade balance to the real exchange rate.
     - Footnote: See Isard and Faruqee (1998) and Isard, Kincaid, and Fetherston (2001). The broader country coverage being implemented here requires a greater variety of fundamentals to “explain” the current account than when the exercise covered only advanced countries.
  2. Reduced-form equilibrium real exchange rate (ERER) approach
     - Directly estimates an equilibrium real exchange rate for each country as a function of medium-term fundamentals such as the net foreign asset (NFA) position of the country, the relative productivity differential between the tradable and nontradable sectors, and the terms of trade.
     - The needed exchange rate adjustment is the difference between the estimated equilibrium real exchange rate and its current value.
     - Footnote: The fundamentals are expected to play a role over the medium term even though exchange rates are essentially unpredictable in the near term (Meese and Rogoff, 1983). Hence, short-term effects of capital flows would eventually disappear, while their medium-term effect should be captured by the underlying fundamentals.
  3. External sustainability (ES) approach
     - Calculates the difference between the actual current account balance and the balance that would stabilize the NFA position of the country at some benchmark level.
     - Using trade elasticities, this difference is translated into the real exchange rate adjustment that—over the medium term—would bring the current account into line with its NFA-stabilizing level, under a particular assumption about the economy’s medium-term growth rate.

### Complementarity, application, and strengths/weaknesses
- The three methodologies provide complementary perspectives and, combined with country-specific information, help form informed judgments about medium-term real exchange rates and current account balances by weighing multiple economic factors.
- Misalignment estimates from the different methodologies are often quite similar for most countries, but differences can arise because:
  - aspects of a particular methodological approach may be less appropriate in some contexts (for example, the ERER methodology may be less accurate for countries with a short sample);
  - difficulties in incorporating critical country-specific information into cross-country approaches;
  - instability of underlying macroeconomic links, cross-country differences in these links, measurement problems for some variables, and imperfect model fit.
- The external sustainability approach can be used to assess the implications for the external position of differing misalignment estimates from the ERER and MB approaches, underscoring the complementary nature of CGER-based assessments with bilateral surveillance.

*Source: _op261*

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_Source: https://www.imf.org/-/media/websites/imf/imported-publications/external/pubs/nft/op/261/_op261.pdf_