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FEERs and the path to EMU.

The concept of the Fundamental Equilibrium Exchange Rate (FEER) was first used in Williamson (1983) to calculate the misalignments of the exchange rates for major currencies, and as a basis for his target zone proposal. In this note we use the same concept in a different context, that of the relations amongst the European economies which are members of the ERM, a system which is evolving towards monetary union. The first section reviews the concept of the FEER and its use in policy analysis. The second section relates this to the analysis of real exchange rates and external balance within a potential monetary union. The third section includes new estimates of FEERs using the most recent version of our world model, and considers the possible future evolution of FEERs in the context of EMU, including some tests of the sensitivity of these estimates to parametric change.

1. The concept of FEERs

The concept of the FEER is described by John Williamson, its originator, in the accompanying note in this Review. it is clearly related to the underlying balance approach to exchange-rate assessment that was developed by the International Monetary Fund. It is defined as 'the rate that is expected to generate a current account surplus or deficit equal to the underlying capital flow over the cycle, given that the country is pursuing internal balance as best it can and not restricting trade for balance of payments reasons' (Williamson, 1985, p. 14).

FEERs have been extensively used in policy analysis. Williamson and Miller (1987) propose a system of target zones for the real exchange rates of the currencies of the main industrial countries around the FEERS. Many studies have evaluated this and other proposals for international monetary reform (Edison, Miller and Williamson (1987), Currie and Wren-Lewis(1989a,b), Frenkel, Goldstein and Masson (1989a, b)).

First estimates of FEERs were presented in Williamson (1983, 1985). Barrell and Wren-Lewis (1989) used a steady state version of GEM to calculate the FEERs for the G7. Wren-Lewis et al (1991) calculate the FEER of the UK to evaluate the entry rate into the ERM(1). Williamson (1990) compares estimates of FEERs derived from several models, including GEM. These are discussed in the accompanying article by Williamson in this Review. Williamson (1990) recognises the normative nature of the FEERS; they could have been called the 'optimum' or' appropriate' exchange rates. They are based on targets for both internal and external balance. In the case of internal balance the target cannot for long differ from the equilibrium level of output which corresponds to the NAIRU. In the case of external balance, the target must be related to some notion of underlying' or "structural' capital flows.

In the long run the full equilibrium position must be seen in terms of asset stocks rather than capital flows. It is important therefore to distinguish the FEER from the long-run equilibrium real exchange rate that would emerge when all stocks of assets are in equilibrium. In such an equilibrium it is possible that capital flows might be zero. In contrast to this, the FEER is a medium-term concept. One could think of the 'structural' capital flows which are used as a guide to the estimation of FEERs as flows which contribute to the adjustment of asset stocks towards their long-run equilibrium.

Capital flows engendered by stock disequilibrium can persist for many years. Net outward capital flows reflect a surplus of domestic saving over investment, and such a surplus can persist for long periods of time. The steady state equilibrium path for an economy may require that the wealth income ratio is constant. However, many factors may cause the level of wealth to rise relative to income over extended periods of time. For instance a country may wish to increase its level of wealth because of demographic developments. Masson and Tryon (1990) argue that high levels of saving in Germany and Japan in the 1980s have been driven largely by demographic factors, and as the populations age they will begin to dissave, probably during the early decades of the next century. Clearly wealth accumulation caused by demographic factors can be a major cause of structural capital flows. A country can only increase its wealth by productive investment at home or by buying assets overseas. The allocation of saving and wealth will depend upon the relative rates of returns at home and overseas. Returns may differ substantially between locations for significant periods of time, and they may also cause long-term capital flows (2)

The concept of the FEER was developed as an alternative to the purchasing power parity approach, which has major practical and theoretical drawbacks. Even the full stock equilibrium is not necessarily associated with PPP. it is generally accepted that there can be long-term or even permanent departures from PPP, especially if it is measured in terms of the goods that a country produces, rather than the goods it consumes. We would assume that producers generally face downward sloping demand curves for their goods, and that products are differentiated. The FEER is generally calculated using a large econometric model and its estimates of trade elasticities and internal balance parameters. The target current balance is determined by the estimate of structural capital flows. The combination of non infinite trade elasticities and estimates of medium-term structural capital flows will generally produce estimates of the FEER that differ substantially from PPP.

If PPP held then we would expect relative price elasticities in our trade equations to be exceptionally large. However, estimated elasticities are generally well below infinity. The smaller are the trade elasticites in a world with differentiated products the larger the effect on the FEER either the current balance target or from a change in other factors such as the demand for the goods of the country in question. It has also been accepted since at least the study of Houthakker and Magee (1969) that in a world with differentiated products the income elasticities of demand for exports may differ between countries. Those countries with low elasticity exports compared to their imports will tend to have to depreciate over time, and the lower their trade elasticities the more rapid the rate of depreciation that is required for a given set of unfavourable demand trends. Hence our estimated FEERS, which depend upon the demand and price elasticities in our trade equations, generally display slowly evolving trends.

2. FEERs in a monetary union Williamson developed the idea of the FEER as a tool for analysing systems of floating or adjustable nominal exchange rates. But the FEER refers to the real exchange rate, or relative prices, and it can be calculated just as well for currencies which have joined a fixed exchange-rate system, or indeed for countries which are part of a monetary union. If nominal exchange rates are fixed then changes in real exchange rates will come about through differential price movements in the countries concerned. Such adjustments are likely to be slow, certainly much slower than the sometimes instantaneous changes in nominal exchange rates under floating rates or adjustable rate systems. The evidence in WrenLewis etal(1991) and in Barrell, Gurney and in't Veld (1991) suggests for example that the UK could take up to five years for lower inflation to reverse three-quarters of a 10 per cent real exchange-rate misalignment.

Adjustments of this kind must continue to take place within a monetary union, since there are many reasons why relative prices in the different countries may get out of line with the equilibrium relationship. If the demand for the output of a country changes permanently then the equilibrium real exchange rate will change and adjustment in the relative price level will have to take place. A good example (of relevance for a potential monetary union in Europe) is the effect that a permanent change in the price of oil would have on the equilibrium real exchange rates of the UK and the Netherlands, both of whom are substantial energy producers. A further example, to which we will return below, is the effect of German re-unification on the German FEER. The economy will be transformed in a number of ways, and demand will increase and supply will be augmented. There will also be, in the medium term at least, an increase in profit opportunities within Germany, and hence we would expect the net structural capital outflow to decline. In both these examples the pattern of FEERs will have to change and relative price levels will have to adjust in order for equilibrium to be achieved. A permanent structural change that changes the FEER will cause the market mechanism to produce the adjustment required. The oil price shock is a good example. It will initially cause current account surpluses and wealth will be accumulating more rapidly in the UK and the Netherlands then had been judged desirable. This accumulation of overseas assets will gradually drive consumption upwards, and the economy will tend to operate above capacity. This will, in a world of differentiated products, cause output prices in these countries to rise relative to those elsewhere and the real exchange rate will adjust.

Other disturbances to international balance may be of their nature transitory. An example would be the effects of a higher level of government expenditure (say to finance a war or economic reconstruction) persisting for a limited time and associated with a move to a higher stock of government debt relative to national income. The build-up of debt would be associated with current account deficits and a declining stock of net overseas assets. Structural capital inflows might be positive whilst this adjustment was taking place. Another example would be the deficit on the current account in the UK during the period of adjustment that followed from the deregulation of credit. It is not clear in these temporary shock cases that relative prices within a monetary union will ever have time to adjust whilst the 'structural' capital flows continue, as the FEERs analysis suggests that they should. It is necessary however that in the longer run relative prices do adjust to the new stock equilibrium which will be achieved after the period of extra spending comes to an end. Within a monetary union it should be easier to finance current account imbalances and associated capital flows which persist in the medium term. This does not mean however, that the 'misalignment' of relative prices can be left uncorrected indefinitely. in the end, by one means or another, the equilibrium pattern of relative prices must be achieved.

It follows that an analysis of equilibrium real exchange rates has implications for the sustainability of a monetary union in Europe. The union will be easier to hold together the less the relative price adjustment that has to take place between countries. If relative prices are seriously out of line, a country which is uncompetitive will have exports below equilibrium, imports above, and its stock of external assets will be progressively drained by a current account deficit, even if that deficit is both unmeasured and easily financed. If the union holds, adjustment will be completed by a relative fall in the domestic price level due to reduced demand for domestic production and by reduced domestic demand for imports. Relative price adjustments of this sort are generally associated with recessions and booms, and adjustment may be slow and painful. Macroeconomic coordination in the union will be easier the fewer the changes in equilibrium real exchange rates, the easier the adjustment of wages and prices and the more similar the structure of the economies concerned.

The formation of a monetary union, together with the measures taken to form a single European market will make goods produced in different countries closer substitutes one for another. This should have the effect of raising the relative price elasticities in mutual trade relationships. The greater these elasticities the less the adjustment in real exchange rates required in response to any shock of given size. Relative prices will need to change less-and incidentally stay closer to PPP. They should also change more rapidly as the size of the effect of relative prices increases. The need for lengthy or costly periods of adjustment should therefore be reduced.

3. The calculation of FEERs We have used steady state GEM to calculate FEERs on previous occasions (Barrell and Wren-Lewis (1989), Wren-Lewis and Barrell(1990)). We have now revised our maquette in order to put our analysis of FEERs and EMU in the context of the world as we currently understand it. We are continually revising GEM in order to take on board new data and to improve model properties. We are always testing our equations to see if they are stable across regime changes such as the shift from flexible to more fixed, or managed, exchange rates in the 1980s. We have found evidence for structural change in trade relations for the UK, France and Japan. For the latter two economies trade competitiveness elasticities seem to be slightly higher in the late 1980s than they were in the 1970s. There is some evidence in Rousse (1991) and in Barrell (1988) that estimated trade price elasticities had been declining up until the mid-1980s, and it is possible that these decline shave been reversed. More open competition in Europe and the reduction in barriers to trade that have resulted from the move towards a single market should increase the effect of competitiveness on trade.

Our estimates of FEERs for the major six economies are given in charts 1 to 6 along with our estimates of the actual real exchange rates over the period. In order to calculate the FEER we have to assume a target current balance. For these charts we assume that the FEER would be achieved if the US had a 1 per cent of GNP structural deficit, Germany had a structural surplus of 4 per cent of GNP, Japan had a 3 per cent of GNP structural surplus, and Canada had a 1.5 per cent of GNP structural deficit. The other three members of the G7 are assumed to have needed current balances equal to zero over this period. Our FEERs are calculated consistently across countries so that the (industrial production) weighted average of FEERs is approximately constant at 1 and our estimated structural surpluses/deficits have been chosen both to ensure this property holds and to reflect longer term trends in the economies concerned. These surpluses imply that if we had seen FEER based equilibrium in the 1980s we would have seen structural outflows from the G7 of around 3/4 of a per cent of their GNP.

These charts are produced using the ratio of overseas prices to domestic prices, and a rise in the FEER implies a depreciation. Table 1 gives our estimates of FEERs over the last two years and compares them to observed real exchange rates. Chart 1 shows a gradual depreciation of the FEER for the United States over the 1980s. During most of the decade the US was running fiscal deficits that were causing the government debt to income ratio to rise. This in turn caused current account deficits and the decumulation of overseas assets. In order to hit a current account target the US real exchange rate would need to continually depreciate in order to engender trade flows to offset the loss of net overseas property income. The FEER in the US does this up until 1987/88 when the budget deficit as a per cent of GNP began to decline to more sustainable levels. We estimate that the dollar was undervalued in real terms in late 1990 by around 5 per cent. As table 1 shows, the recent appreciation of the dollar has more than eliminated this undervaluation and the dollar appears now to be overvalued. A real depreciation of around 5 per cent is required for the real exchange rate to reach its equilibrium.

The path of the FEER for Japan shows a gradual appreciation over the 1980s. This reflects in part the gradual build up of overseas assets. Continued surpluses raise net property income and the exchange rate required to achieve a given current balance target will have to appreciate over time. The pattern of asset accumulation is not the only factor causing FEERs to trend. Japan would have had an appreciating FEER even if its current balances had been zero over the 1980s. Our model suggests that the demand for Japanese exports would grow more rapidly than elsewhere if all other factors were constant. In order to maintain current balance equilibrium Japan would therefore have to continually appreciate.(3) Chart 2 shows that the yen has been undervalued for most of the last decade and we estimate that the yen is undervalued by around 15 per cent now. The yen appears to have been around its FEER in 1988 and 1989, but the sharp depreciation during 1990 pushed it well away from our estimate of the FEER. This change in the real exchange rate, which may have been caused by temporary financial factors, has only partly been reversed in the last year.

The path of the FEER for Germany shows a similar appreciation. As for Japan, this reflects in part the accumulation of overseas assets and the associated rise in net property income, and also the trend in German exports, and these together require a continuous appreciation. It appears that the D-Mark was undervalued for much of the 1980s. This undervaluation reflects the set of exchange rates in Europe in 1983 when the ERM went 'hard'. We would argue that eventually this under-valuation would be eroded by changes in relative price levels. As we will see below, we find that French, Italian and UK currencies were overvalued by the end of 1990. The appreciation of the dollar between February and May 1991 will have reduced the overvaluations of most of the European currencies. if nothing else had changed it would have exacerbated the undervaluation of the D-Mark, but would on average have reduced adjustment problems in the EMS.

The reunification of Germany has, however, changed economic prospects quite fundamentally . We are now projecting a period of much more moderate current balance surpluses over the next five years. This is in part because the German economy is currently operating close to or above its capacity ceiling. Moreover, unification will result in lower levels of structural capital outflows as profit opportunities open up in the eastern Lander. if we retain the idea of the FEER as reflecting these medium-term structural flows, unification will have to be associated with an appreciation in the FEER. if we abstract from this effect then we would judge that the D-Mark was 5 to 10 per cent undervalued when the UK joined the Exchange Rate Mechanism in 1990. The overall undervaluation of the D-Mark has been exacerbated by the recent appreciation of the dollar, but this has left it little changed against its Community partners.

Our estimates of the FEERs for France and italy are given in charts 4 and 6. Both appear to have moved from a position of general undervaluation to one where both are probably overvalued. This reflects in part the tendency in the 1980s for realignments in the ERM to not fully reflect inflation differentials. As we move to an even harder ERM the anti-inflationary discipline of the 1980s has left the French probably 5 to 10 per cent overvalued, and the italians at least 1 0 per cent overvalued. This will be a major factor behind the slowdown in both economies in 1991 and the several years of lower than capacity output that is discussed in Chapter 11 of this Review, and it is a major factor behind our forecast of slower inflation in France than in Germany for much of the 1990s. However, the combination of the size of the Italian misalignment and the continued positive inflation differential against Germany lead us to believe that the Italian economy will need at least one more realignment before it can enter a monetary union.

The path of the FEER for the United Kingdom in chart 5 shows a gradual appreciation. The temporary effect of oil related surpluses in the UK has meant that the FEER appreciated over the 1980s as assets built up. In October 1990, when the pound sterling joined the ERM, we estimate that at most the pound was 10 per cent overvalued. Since then the appreciation of the dollar has removed approximately half of this overvaluation and it appears that the pound is now overvalued by only around 5 per cent. Given the pattern of misalignments in the Community we do not think that this overvaluation is insurmountable. Given that we estimate that the real effective D-Mark rate is 10 per cent undervalued, correction of the current pattern of misalignments would require that over the next decade prices in the UK should rise by 10 per cent or so less than those in Germany. This is no larger than the change in relative price levels that is required to remove the current French overvaluation against Germany. The forecasts contained in Chapters I and II of this Review do suggest that UK and French inflation will be below that in Germany for most of the 1990s.

The major exchange-rate problem facing the Community in the transition to Monetary Union appears to be the significant undervaluation of the D-Mark. Most commentators rule out an upward re-alignment because it would engender a loss of credibility on the part of the authorities. The real exchange rate for Germany could still appreciate as a result of nominal exchange-rate appreciation of all EMS currencies against the dollar or the yen. But this would not ease the tensions within the EMS itself. To bring the different countries of Europe into an equilibrium relative price relationship the rate of inflation would need to be lower in Germany than in France, Italy and the UK for a period of a several years.

We have stressed above that FEERs may have trends, and chart 7 plots the projected FEERs in the 1990s for the four major European economies. The progressive nature of German trade has been associated with a gradual appreciation of the FEER, and we believe that the D-Mark would continue to appreciate in real terms even if the current balance were zero. Not all FEERs can appreciate, because they are relative prices. We project that the FEERs for the UK, France and Italy all need a slow depreciation over time. Table 2 shows one possible combination of FEERs for the four countries projected forward to the end of 1995. The required differences in rates of inflation are also shown. These differentials, which we would expect to continue to evolve, have to be added to those that are required to remove the initial misalignment of the ERM currencies. However, these inflation differentials associated with the evolution of FEERs over time do not have the same connotation as those required by real misalignments. They do not represent adjustment to disequilibrium, and they should be 'anticipated' as they reflect very long-term trends. They should therefore be taken into account by wage and price setters. These long-run output price level trends are associated with an equilibrium path for the economy, and do not necessarily require temporary recessions to bring them about. The same cannot be said for the price level changes required by misalignment.

Our estimates of FEERs are dependent upon our assumptions about trade elasticities and our current balance targets, and it is useful for our analysis of FEERs and EMU to undertake some analysis of these effects. In order to test the sensitivity of these numbers to the size of trade elasticities alternative calculations are shown in table 3. Estimates of trade elasticities vary widely and, as mentioned above, there is evidence that trade elasticities are rising. Table 3 was calculated with all trade elasticities in our model raised by 50 per cent. As we would expect higher trade elasticities reduce the amount of adjustment that is necessary. Policies that the Community can undertake that will raise trade elasticities will make EMU easier to attain, and more likely to endure. The obvious steps to take are faster removal of all tariff and non-tariff barriers to trade and a greater effort at promoting competition.

Our estimates suggest that a 50 per cent increase in trade elasticities would reduce the trend appreciation of the D-Mark by about 1/3 to less than 1/2 per cent per annum, and it would cut the trend depreciations for both Italy and the UK by about 112 per cent a year. Inflation differentials against Germany would be reduced to around 1 per cent per annum for the other three countries. The higher elasticities also produce a German FEER that would be closer to the actual real exchange rate, and it cuts the undervaluation of the D-Mark at the end of 1990 from around 6 per cent to about 3 per cent. Higher trade elasticities also reduce the overvaluation of the lire (4).

It is useful to analyse the effects of a change in current balance targets in the context of German reunification. it is as yet unclear what structural changes will take place in the new Germany, but higher profit opportunities should reduce the capital outflow from the country. Table4 gives three different estimates of the FEER dependent upon the level of structural capital outflows produced by the new Germany. In each case we assume that the structural capital outflow from the G7 is reduced, and other countries, current balance targets are unchanged. (However, as table 4 shows, in an interdependent world their FEERs may change a little). The larger the reduction in the structural capital outflow the greater the required appreciation of the German FEER. Hence German unification is likely to worsen the existing pattern of misalignments in the Community, and without a change in the value of the D-Mark we can expect it to increase the costs of relative price adjustment that face the European economies on the road to EMU.

In concluding it should be stressed that the FEER analysis does not necessarily have normative significances in the context of monetary union, at least of the kind attributed to it by John Williamson in his analysis of the world monetary system. Changes in medium-term structural capital flows, such as those required by the reconstruction of the East German economy do not necessarily call for changes in nominal exchange rates to bring about a matching current account equilibrium. The alternatives may include planned differences in the pressure of demand in different countries-that is divergence from internal balance-or at least in the short term, differences in the expected return on assets denominated in different currencies. The value of the analysis in terms of FEERs is that it points to the need for a solution of one kind or another.


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1. Other examples of the determination of FEERs are given in Alogoskoufis (1989) and in't Veld (1991).

2. This is the essential argument of the Kiel Institute in Schatz etal, (1988). They demonstrate that the real rate of return to industrial investment in Germany in the 1980s was exceptionally low, and hence contributed to the large net capital outflow from Germany over the same period.

3. Our econometric work on Japan, reported in National Institute Economic Review no. 133 August 1990, suggests that trade equations in Japan displayed a structural break in the late-1980s, and that the scale of the positive time trends was significantly reduced. This change is reflected in our estimate of the FEER.

4. However, our trade elasticities are part of an estimated system, and an increase in the price elasticity must be reflected in a change in another parameter. Higher trade elasticities for France, given past data, are associated with less advantageous trade trends and hence the FEER is little affected.
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Title Annotation:fundamental equilibrium exchange rate; European monetary union
Author:Barrell, Ray; Veld, J.W. in't
Publication:National Institute Economic Review
Date:Aug 1, 1991
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Next Article:Comparative properties of models of the UK economy.

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