## Thursday, June 08, 2023

### Aligning Exchange Rates to Economic Fundamentals

In this blog post(AI generated), I will discuss how to align the exchange rate to economic fundamentals without devaluation or adopting a flexible exchange rate regime. This is a challenging task for many countries that face external imbalances, inflationary pressures, or financial instability.

The exchange rate is the price of one currency in terms of another. It reflects the relative demand and supply of different currencies in the global market. Economic fundamentals are the underlying factors that determine the equilibrium exchange rate, such as productivity, trade balance, fiscal policy, inflation, and interest rates.

One approach to align the exchange rate to economic fundamentals is to use the Fundamental Equilibrium Exchange Rate (FEER) method. This method involves calculating the real exchange rate that equates the current account at full employment with sustainable net capital flows. The FEER is the exchange rate that would prevail if the economy were operating at its potential output and external balance. If the actual exchange rate deviates from the FEER, it implies that the currency is overvalued or undervalued.

To explain the FEER method more, let me use an example. Suppose a country has a current account deficit of 5% of GDP and a potential output growth of 3%. The FEER method would estimate the real exchange rate that would reduce the current account deficit to a sustainable level, say 2% of GDP, given the potential output growth. This would require a depreciation of the real exchange rate to make the country's exports more competitive and imports more expensive. The FEER method would also take into account the net capital flows that are consistent with the desired current account balance and the intertemporal budget constraint of the country.

Another approach to align the exchange rate to economic fundamentals is to use the Behavioral Equilibrium Exchange Rate (BEER) method. This method involves estimating a reduced-form equation that relates the real exchange rate to a set of explanatory variables that capture the economic fundamentals. The BEER is the exchange rate that is consistent with the observed behavior of agents in the economy. If the actual exchange rate deviates from the BEER, it implies that there are temporary shocks or market imperfections that distort the exchange rate.

To explain the BEER method more, let me use an example. Suppose a country has a real exchange rate of 1.2 and a set of economic fundamentals such as productivity, trade balance, fiscal policy, inflation, and interest rates. The BEER method would estimate a regression equation that relates the real exchange rate to these variables using historical data. The equation would have a constant term and coefficients for each variable that measure their impact on the real exchange rate. The BEER method would then plug in the current values of these variables into the equation and obtain a predicted value for the real exchange rate, say 1.1. This would indicate that the actual exchange rate is overvalued by 0.1 compared to the BEER.

Both methods have advantages and disadvantages. The FEER method is normative and prescriptive, as it reflects what the exchange rate should be rather than what it is. The BEER method is positive and descriptive, as it reflects what the exchange rate is rather than what it should be. The FEER method requires more assumptions and judgments about the potential output and sustainable net capital flows. The BEER method requires more data and econometric techniques to estimate the equation.

To align the exchange rate to economic fundamentals without devaluation or adopting a flexible exchange rate regime, a country needs to adjust its macroeconomic policies and structural reforms to influence the demand and supply of its currency. For example, a country with an overvalued currency can reduce its fiscal deficit, increase its domestic savings, promote its exports, diversify its production structure, and liberalize its capital account to increase the demand for its currency and reduce its supply. A country with an undervalued currency can increase its fiscal spending, reduce its domestic savings, stimulate its imports, upgrade its technology level, and regulate its capital account to reduce the demand for its currency and increase its supply.

Aligning the exchange rate to economic fundamentals without devaluation or adopting a flexible exchange rate regime is not easy or quick. It requires coordination and consistency among different policy instruments and objectives. It also depends on the external environment and the reactions of other countries. However, it can help a country achieve a more stable and sustainable macroeconomic performance in the long run.