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Estimates of the Fundamental Equilibrium Exchange Rate of Kuna

Estimates of the Fundamental Equilibrium Exchange Rate of Kuna. Katja Gattin Turkalj Croatian National Bank. Introduction. Real Equilibrium Exchange Rates. A “fair” value of a currency

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Estimates of the Fundamental Equilibrium Exchange Rate of Kuna

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  1. Estimates of the Fundamental Equilibrium Exchange Rate of Kuna Katja Gattin TurkaljCroatian National Bank

  2. Introduction

  3. Real Equilibrium Exchange Rates • A “fair” value of a currency • Getting the rate “right” is of great importance as the exchange rate influences competitiveness, price trends and other key macroeconomic variables. • Various concepts of EER, depending on the definition of internal and external balance

  4. FEER • Fundamental equilibrium exchange rate • FEER is the real effective er that secures internal and external balance for a country (or for a number of countries) simultaneously. • Internal balance: NAIRU • External balance: "sustainable" BoP position

  5. FEER • Advantages: does not require to much data, easily computed, and tested in the literature many times • Drawbacks: normative elements, ad hoc definition of sustainable CA position, difficult to model trade, but… • “Possibly the most popular of the underlying balance models” (Driver and Westaway, 2001)

  6. Trade, capital flows and ER in Croatia

  7. Index of Real Exchange Rate

  8. Nominal ER of Euro and USD

  9. PPI for Croatia, EU, and relative PPI

  10. Construction on IREER

  11. Export of goods and services

  12. Imports of goods and services

  13. Destination of exports

  14. Changes in trade patterns • WTO 2000 • Bilateral agreements (first signed in 1996, by the end of 2004 25 agreements) • EFTA 2001 • SAA 2001 • CEFTA 2003 • Return of export markets of former YU

  15. Liberalization of capital flows • New FX law in 2003 • Liberalization especially for firms • Very few restrictions remain (some short-term flows, outflow of capital for residents, real estate, …) to be lifted by the end of SAA (2007)

  16. Estimating FEER

  17. Concepts of equilibrium ER • market equilibrium: balances supply and demand of currency (Williamson) • current equilibrium: consistent with the given or current fundamentals • medium term equilibrium: consistent with the fundamentals at their equilibrium level • long term equilibrium: in the long run, the capital stock and foreign debt are also endogenous and will be related, along with the real exchange rate, to long run fundamentals

  18. Estimates of the EER • PPP, HBS and NATREX are long-term concepts, • On the short end, there are purely statistical approaches SVAR, BEER and CHEER • FEER, DEER and PEER, refer to modeling the medium term equilibrium.

  19. Estimating FEER • Internal eq: potential GDP growth associated with low and "non-accelerating" inflation rate • 1) Output gap • 2) HP filter or BN decomposition

  20. Estimating FEER • External eq: • 1) Macroeconomic balance approach (IMF) • S(X)-I(Y)=CA (rer, Ybar) • X and Y are arrays of explanatory variables (fiscal position, openness, population growth...) • 2) "sustainable" current account position...

  21. Estimate Trade balance • and elasticities of imports and exports relative to the exogenous variables • + + • + -

  22. Solve for FEER • CA= X-M • FEER is the solution for RER in • when CA, Y and Y* are replaced with their long term values

  23. Estimate X and M equations… DLOG(X) = -5.25 + 1.10*LOG(RER) + 3.44*DLOG(M*(-1)) + 4.58*DLOG(M) (-2.18) (2.12) (5.01) (12.16) R2=0.79 F-stat=53.9 DLOG(M) = 0.47 + 1.09*DLOG(Y) - 0.10*LOG(RER) (0.30) (4.18) (-0.29) R2=0.27 F-stat=8.54

  24. Actual REER and FEER

  25. Conclusion • The drawback inherent in the FEER method, cannot be resolved within the framework of FEER • Often, another method is used along with FEER to verify its findings (BEER)

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