V Conclusions

Jaewoo Lee, Jonathan Ostry, Alessandro Prati, Luca Ricci, and Gian Milesi-Ferretti
Published Date:
April 2008
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This paper has presented three alternative methodologies to help gauge the consistency of current account balances and real effective exchange rates with their underlying fundamentals. While assessments of exchange rate misalignment will always need to be informed by country-specific factors that are difficult to incorporate into studies based on large cross-country data sets, the consistent multilateral approach developed in the foregoing sections should nevertheless prove useful and complementary to the approaches pursued at the IMF country desk level.36

The three approaches are also intended to be complementary to one another in the process of arriving at “exchange rate assessments.” In many cases the different approaches will yield qualitatively and even quantitatively similar results, but this will not necessarily be the case: the ERER approach focuses directly on prices (exchange rates), while the other two approaches focus on quantities (current accounts and net foreign assets) and then derive the implications for the exchange rate. This difference in focus also implies some differences in the fundamentals being captured under each of the approaches.37 Indeed, the process of arriving at exchange rate assessments is not a mechanical one, in which the results of applying one particular methodology are imposed, or a simple average among all the available approaches is used. For example, a methodology’s estimate for a specific country may be disregarded in light of factors such as data limitations, a short sample, and large sensitivity of that country’s results to minor modifications in the methodology.

The importance of avoiding a mechanical assessment is underscored by the uncertainty surrounding econometric estimates, the inability to fully incorporate all relevant country-specific factors, issues related to data availability and reliability, and potential shifts in the underlying macroeconomic and structural relationships. These problems may be particularly severe for countries undergoing rapid structural change and for those for which sample length is relatively short.

This paper’s other main contribution is to explicitly recognize the much greater weight of key emerging market countries in the problem of global imbalances and currency misalignments. While past exchange rate assessments had an entirely advanced-economy focus, the work developed in this paper is based on a much larger sample of both emerging and advanced economies, and hence is able to capture a much greater share of global trade. This should allow more balanced judgments to be reached on how currencies—of both advanced and emerging economies—ultimately may need to adjust as the currently sizable global current account imbalances are narrowed.

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