EstimatingConsistentFundamentalEquilibriumExchange.PDF

Working Paper S e r i e s W P 0 8 - 6 J U L Y 2 0 0 8 Estimating Consistent Fundamental Equilibrium Exchange Rates William R. Cline Abstract This paper sets forth a new methodology for obtaining a consistent set of exchange rate realignments needed to accomplish international adjustment in current account imbalances to reach fundamental equilibrium exchange rates (FEERs). The approach is named the symmetric matrix inversion method (SMIM). It is symmetric in that it treats all countries considered equally rather than seeking exact adjustment for the United States and obtaining other adjustments residually. Country-specific impact parameters based on assumed trade elasticities are applied to a target set of changes in current accounts as percentages of GDP to obtain a corresponding set of target changes in real effective (trade-weighted) exchange rates. A matrix inversion technique is then applied to identify the corresponding set of changes in bilateral exchange rates against the dollar needed to approach as closely as possible the target set of effective exchange rate changes. JEL Codes: F31, F32 Keywords: Exchange Rates, Current Account Adjustment, Dollar William R. Cline is a senior fellow jointly at the Peterson Institute for International Economics and the Center for Global Development. He has been a senior fellow at the Institute since its inception in 1981. During 1996– 2001, while on leave from the Institute, he was deputy managing director and chief economist at the Institute of International Finance. He was a senior fellow at the Brookings Institution (1973–81); deputy director of development and trade research, office of the assistant secretary for internati