A Paper Presentation on

EQUILIBRIUM EXCHANGE RATE
Theme: International Finance & Trade
Institute Name: Symbiosis Institute of International Business (SIIB), Pune Student Name: 1) Swapnil Rathi 2) Kuldeep Joshi Contact No: Swapnil – 9860222020 Kuldeep – 9028029154 Email id: swapnilrathi@siib.ac.in kuldeepjoshi@siib.ac.in

1

ABSTRACT

The exchange rate is the rate at which the supply for a currency meets the demand of the same currency. As foreign exchange rates are affected by a number of factors,

the equilibrium exchange rate in turn, are also influenced by its supply and demand. Hence equilibrium is achieved when a currency's demand is equal to its supply. Analysing the equilibrium levels of the exchange rates plays a crucial role in the policy making decisions of the policymakers. Exchange rates have a major influence on the prices faced by the consumers and producers throughout the world and the consequences of misalignments can be extremely costly to the nations involved. Therefore economists have developed number of methodologies for calculating the exchange rates. Each methodology involves conceptual explanations and/or imprecise estimates of key parameters and different methodologies which generate different calculated values for equilibrium exchange rates. This makes it difficult to have much confidence in estimates derived from any single methodology on its own. By the same token, it suggests that, ideally, policymakers should inform their judgments through the application of several different methodologies. Various long run models like PEER, APEER, Natrex and short run models like BEER and CHEER are used to calculate the equilibrium exchange rate. The overshooting model is used to explain why the exchange rates with huge variance. The paper explains the basic concept of equilibrium exchange rate in international foreign currency exchange along with the different models to calculate it over short, medium and long term prospects.

Keywords: Methodologies, BEER, CHEER, PEER, APEER.

2

Table of Contents Sr. No 1 2 3 4 5 6 7 8 9 10 11 Introduction Importance of Exchange Rates Law of One Price Purchasing Power Parity Real Exchange Rate (RER) Fundamental Equilibrium Exchange Rate (FEER) NATREX Overshooting Model Conclusion References About the Authors Topic Page No 4 4 5 6 7 13 18 22 23 24 25

3

1. Introduction

Foreign exchange market is the trade between countries which involves the mutual exchange of the different currencies. The volume of these transactions worldwide averages over $1 trillion daily. The price of one currency in terms of another is called the exchange rate. A foreign exchange rate, which is also called a forex rate or currency rate, represents the value of a specific currency compared to that of another country. Currency rates are applicable only on currency pairs. The currency listed on the left is called the reference (or base) currency while the one listed to the right is the quote (or term) currency. E.g. $1 = ` 49.181 There are two kinds of exchange rate transactions. The predominant ones called spot transactions involving the immediate exchange of bank deposits and Forward transactions involve the exchange of bank deposits at some specific future date. The spot exchange rate is the exchange rate for the spot transactions and the forward exchange rate is the exchange rate for the forward transactions. When a currency increases in value, it experiences appreciation, when it falls in value and is worth fewer US dollars, it undergoes depreciation.

2. Importance of Exchange Rates

Exchange rates are important because they affect the relative price of domestic and foreign goods. The dollar price of French goods to an American is determined by the interaction of two factors: the price of French goods in euros and the euro/dollar exchange rate. When a country‟s currency appreciates (rises in value relative to other currencies), the country‟s goods abroad become more expensive and foreign goods in that country become cheaper (holding domestic prices constant in the two countries). Conversely, when a country‟s currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive.

2.1 Trading of Foreign Exchange

Currencies are not traded on exchanges such as the NYSE, instead, the foreign exchange market is organized as an over- the-counter market in which the several hundred dealers (mostly banks) stand ready to buy and sell deposits denominated in foreign currencies.
4

Because these dealers are in constant telephone and computer contract, the market is very competitive, in effect; it functions no differently from a centralized market. Finally, when a bank is buying dollars in the foreign exchange market, they are actually buying deposits denominated in dollars. Factors affecting long run Exchange rates.     Relative price levels, tariffs and quotas, preference for domestic versus foreign goods and productivity. Relative Price Levels: According to PPP, when price of American goods rise, the demand for American goods fall and $ tends to depreciate. Trade Barriers: Increasing trade barriers causes the country‟s currency to appreciate. Domestic vs. Foreign goods: Increased demand for a country‟s export causes its currency to appreciate in the long run; conversely, increased demand for imports causes domestic currency to appreciate.

2.2 Changes in equilibrium Exchange rates

1. Domestic Interest rate changes - When Domestic real interest rate rises, the domestic currency appreciates. When Domestic interest rate rise due to an expected increase in inflation, the domestic currency depreciates. 2. Changes in Money Supply: A higher domestic money supply causes the domestic currency to depreciate.

3. Law of One Price

Law of One price is the starting point for understanding how the exchange rates are determined. Consider a scenario where two countries produce the same good, with the same labour. The price of that good should be same throughout the world irrespective of the country. Suppose India produces 100 kg of wheat for ` 2000/- and America produces the same wheat of 100 kg at $40. For the law of one price to hold, the exchange rate between Rupee and Dollar must be ` 50 per Dollar so that 100 kg of American wheat sells for ` 2000/- in India and 100 kg of Indian wheat sells for $40 dollars in America. If the exchange rate would have been ` 100 for $1, Indian wheat would sell for $20 dollars in America and American wheat would sell for ` 4000 in India. Hence American steel will cost double in both the countries and will be not being sold in any of the countries.

5

4. Purchasing Power Parity

Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must depreciated in order to return to PPP. The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. For example, a particular TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver. If this process (called "arbitrage") is carried out at a large scale, the US consumers buying Canadian goods will bid up the value of the Canadian Dollar, thus making Canadian goods more costly to them. This process continues until the goods have again the same price. There are three limitations with this law of one price. 1. As mentioned above, transportation costs, barriers to trade, and other transaction costs, can be significant. 2. There must be competitive markets for the goods and services in both countries. 3. The law of one price only applies to tradable goods; immobile goods such as houses, and many services that are local, are of course not traded between countries. Short Run Approach: Exchange rate is the price of domestic bank deposits in terms of foreign bank deposits. The natural way to investigate determination of exchange rates is through an asset market approach. Long Run Approach: Long run approach is on import, export demand while asset market approach used does not emphasize flow of purchases of exports and imports because these transactions are small. Thus in short run decisions to hold foreign assets are major in exchange rate determination.

6

5. Real Exchange Rate (RER)

The real exchange rate can be defined as the nominal exchange rate that takes the inflation differentials among the countries into account. Its importance stems from the fact that it can be used as an indicator of competitiveness in the foreign trade of a country. RER assumes utmost importance in developing countries where non-tradable goods constitute a large segment of the goods market and only their prices are flexible as prices of traded goods are largely determined in world market. Therefore, the volatility in the prices of non-traded goods leads to misalignment of RER from its equilibrium level and supposedly, affects adversely the competitiveness and economic growth.

5.1 The Definition on the Basis of the Tradable and Non-tradable Goods

The definition takes the relative price of the tradable and non-tradable goods in the country as an indicator of the country‟s competitiveness level in the foreign trade. The rationale behind this definition is that the cost differential between the countries is closely related with the relative price structures in these economies. Under the assumption that the prices of the tradable goods will be equal all around the world, the real exchange rate defined on the basis of tradable and non-tradable goods distinction can be mathematically represented as: Rr = Pt/Pn = e (P*t/Pn) (1)

In this definition, Pt and Pt* stand for the domestic and international prices of the tradable goods respectively, while the prices of the non-tradable are denoted by Pn, e is the nominal exchange rate defined as units of home currency to a unit of the foreign currency .In this definition, the decline of Rr indicates the real appreciation of the domestic currency. Since the RER in equation (1) measures relative prices between countries, it is referred to as external RER. An increase in the value of RER indicates that foreign goods become more expensive relative to domestic goods so that international competitiveness improves. An increase (decrease) in RER is referred to as depreciation (appreciation). RER is used to measure the internal relative price incentive in a particular economy for producing or consuming tradable as opposed to nontradable goods. In this case, the RER is defined as the relative prices of tradable and nontradable goods and is referred to as the internal RER. A rise in the internal RER (a real depreciation) means that the tradable sector has become more competitive in relation to the nontradable sector. Therefore, the incentive structure favors switching of resources from nontradable to tradable production, and demand moves from tradable to nontradable goods.

7

At the simplest level the real exchange rate is given as follows: Q= (E.P*)/P (2)

where: (P) and (*)P are the domestic and foreign price levels, respectively and (E) is the nominal exchange rate expressed as units of domestic currencies per unit of foreign currency. Hence a rise in (E) and (Q) implies a depreciation of nominal and real exchange rate of the local currency, respectively. In the logarithm forms, both domestic price (p) and foreign price (p *) can be expressed in the following manner: p=β.pNT + (1-β).pT p*=β*.p*NT +(1-β*).p*T (3) (a) (3) (b)

Where: pNT and p*NT are domestic and foreign non-tradable prices, respectively and pT and p*T are domestic and foreign tradable price, respectively. (β) and (1− β) are the shares of nontradable and tradable sectors for the domestic economy, while β* and (1−β*) are the corresponding shares for the foreign economy. Substituting Equations (3a and 3b) into Equation (2) we can redefine the real exchange rate (q) as: q= e (β*.p*NT + (1-β*).p*T)/ (β.pNT + (1-β).pT) q= (eB*p*NT + ep*T –eB*p*T)/ (BpNT+pT-BpT) q= (eB*(p*NT-p*T) +ep*T) q= (e+ p*T-p T)-((1-β) (p NT-p T)-(1-β*) (p*NT-p*T)) (4)

Equation 4 suggests that the fluctuations of real exchange rate movements are potentially driven by two different sources, viz. the real exchange rate of tradable goods (e+ p*T-p T ), and the ratio of the domestic to the foreign relative prices of non-tradable and tradable goods (1-β)(p NT-p T)-(1-β*)(p*NT-p*T)). Of course, if Purchasing Power Parity (PPP) in the tradable sector holds then the first term in equation 4 is zero, implying that the real exchange rate is determined solely by the relative gaps in non-tradable and tradable prices domestically if one assume P*NT-p*T= 0, then the real exchange rate is a measure of relative domestic prices of non-tradable to tradable.

8

More generally, equation (4) emphasizes that the movements of real exchange at any point in time can be driven by changes in prices that occur in both the non-tradable and tradable sectors in the domestic country and those in its trading partners, as well as changes in the structures of the two economies (i.e. β and β* ). One of the most important hypotheses with respect to the equilibrium real exchange rate level postulates that rapid economic growth is accompanied by real exchange rate appreciation because of differential productivity growth between tradable and non-tradable sectors. Evidence from developing countries is often quoted to support the view that the link between RER misalignment and economic performance is strong. Even though concepts of the RER are relatively straightforward, a number of choices have to be made when measuring it. These include three key elements: (i) choice of prices, (ii) country weights, and (iii) operational formula to be used.
1) Choice of Prices

The most commonly used price series in constructing RER for measuring international competitiveness are consumer price indices (CPIs). CPI-based RER measures provide a good reflection of the purchasing power of the domestic currency. However, the fact that CPI baskets contain a significant non traded component makes CPI-based RER less than ideal for assessing competitiveness.
2) Which weights to be chosen

The choice of weighting scheme depends crucially on the purpose for which the RER is being constructed. For countries without substantial unrecorded or misrecorded trade, actual trade weights can be used for assessing changes in competitiveness. However, when the inter country pattern of trade is significantly different for imports and exports, it may be preferable for some analytical purposes to use either export or import weights rather than averaging these together. In addition, the weights should reflect reasonably well the structure of trade in the period being analyzed. Using current weight schemes could mitigate the problem of changing trade structure and should be used for current policy analysis
3) REER

The real effective exchange rate is an inflation-adjusted trade-weighted exchange rate. We use the national consumer price indices (CPI) as the basis for the inflation-adjustment. We compute the real effective exchange rate for a given country as a geometric average of that country‟s real bilateral exchange rates against those countries that are its trading partners. Bilateral exchange rate involves a currency pair, while an effective exchange rate is a weighted average of a basket of foreign currencies, and it can be viewed as an overall measure of the country's external competitiveness. The NEER is the weighted geometric
9

average of the bilateral nominal exchange rates of the home currency in terms of foreign currencies. The REER is the weighted average of NEER adjusted by the ratio of domestic price to foreign prices. Compared to NEER, a GDP weighted effective exchange rate might

be more appropriate considering the global investment phenomenon.

Where e: Exchange rate of Indian rupee against numeracies, i.e., the IMF‟s Special Drawing Rights (SDRs) in indexed form

As set out in the methodology, the REER has four parameters/variables pertaining to country/currency coverage (n), relative prices (P/Pi), weights (wi) and exchange rates (e/ei). The new 36-country indices are used by RBI to calculate the REER and NEER. The monthly average of the REER and NEER for the base year is benchmarked to the level of 100. The year 1993-94 is chosen as the base year for the revised 36-currency REER/NEER series in line with the WPI base year.

10

The new six-currency indices represent the US, the Eurozone (comprising of 12 countries), UK, Japan, China and Hong Kong SAR. In line with the existing practice, the revised indices (both 6-currency and 36-currency) use the wholesale price index (WPI) as a proxy for Indian prices and the consumer price index (CPI) as a proxy for foreign partner countries. While CPI is more representative of the cost/ inflationary conditions in the markets to which most of India‟s exports are directed, WPI reflects the producer costs. The weekly wholesale price index (WPI) for all commodities is used as an index of inflation for India in calculating six-currency REER/NEER indices. While the 6-currency index updates the WPI data every week, it is updated monthly for the 36-currency index. Currencies included in the new 36 currency REER/NEER series Australia, Bangladesh, Brazil, Canada, China, Denmark, Egypt, Euro (Includes Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain), Hongkong, Indonesia, Iran, Israel, Japan, Kenya, Korea, Kuwait, Malaysia, Myanmar, Mexico, Nigeria, Pakistan, Philippines, Qatar, Russia, Saudi Arabia, Singapore, South Africa, Sri Lanka, Sweden, Switzerland, Thailand, Turkey, UAE,UK,USA.

11

Table 1 determines the Indices of REER ad NEER with base year as 2004-05 for 36-currency trade based weights and 6-currency trade based weights.
TABLE I (DATE: 25/08/2011 SOURCE: RBI)

APPENDIX TABLE 1: INDICES OF REAL EFFECTIVE EXCHANGE RATE (REER) AND NOMINAL EFFECTIVE EXCHANGE RATE (NEER) OF THE INDIAN RUPEE Year/Month 36 -Currency Trade6 - Currency Trade-based based weights weights (Base 2004-05=100) (Base 2004-05=100) REER NEER REER NEER 1 2 3 4 5 2004-05 100.00 100.00 100.00 100.00 2005-06 103.10 102.24 105.17 103.04 2006-07 101.29 97.63 104.30 98.09 2007-08 108.52 104.75 112.76 104.62 2008-09 97.80 93.34 102.32 90.42 2009-10 (P) 94.74 90.94 101.97 87.07 2010-11 (P) 102.04 93.56 115.28 92.02 2009-10 (P) April 90.62 89.65 96.12 85.28 May 91.89 90.59 98.51 86.48 June 92.70 91.04 98.71 86.71 July 92.03 89.59 97.84 85.22 August 92.50 89.33 98.90 85.04 September 91.72 88.35 98.48 84.18 October 94.33 90.66 101.53 86.67 November 95.66 90.67 102.86 86.56 December 96.19 91.10 103.99 87.21 January 99.11 92.63 107.33 89.30 February 99.10 93.08 107.98 90.03 March 101.08 94.56 111.43 92.19 2010-11 (P) April 103.78 96.35 116.00 94.70 May 102.95 95.55 116.20 94.23 June 102.30 94.66 115.21 93.50 July 99.98 92.03 112.63 90.96 August 99.57 92.02 112.72 90.92 September 100.75 92.87 113.96 91.38 October 102.66 94.51 115.19 92.32 November 101.67 93.34 115.08 91.52 December 103.52 93.82 117.94 92.47 January 102.65 92.72 117.46 91.45 February 101.78 92.32 115.72 90.37 March 102.88 92.54 116.46 90.44

12

2011-12 (P) April May June P: Provisional.

104.37 101.20 101.51

93.02 91.79 92.07

118.78 117.19 117.35

90.60 89.48 89.48

FIGURE 1: REER VS NEER

The above graph shows the NEER and REER for 36 country indices. From this above graph we can conclude that REER for every year is more than NEER.

6. Fundamental Equilibrium Exchange Rate (FEER)

Williamson (1994) defined FEER as a real effective exchange rate that simultaneously secures internal and external balances for a given number of countries at the same time. • Internal balance is reached when the economy is at full employment output and operating in a low inflation environment. • External balance is characterized as a sustainable balance of payment position over a medium-term horizon, ensuring desired net flows of resources and external debt

13

sustainability. A minimum criterion for external balance is that the current account balance has to be sustainable. In this approach the equilibrium exchange rate is defined as the real effective exchange rate that is consistent with macroeconomic balance, which is generally interpreted as when the economy is operating at full employment and low inflation (internal balance) and a current account that is sustainable, i.e., that reflects underlying and desired net capital flows (external balance). In contrast to the PPP approach, the FEER approach recognizes that the equilibrium real exchange rate will vary across time. A number of factors guide the trajectories of the FEER. 1. The first one is related to the determination of potential output growth associated with low inflation in both domestic and foreign economies. Acknowledging potential gaps in productivity growths of Balassa (1964), the FEER will have to appreciate and depreciate over time as countries grow at different rates 2. The second is to address what would be considered as a sustainable current account level. Maintaining current account balance at a targeted rate requires the local currency to appreciate and depreciate accordingly. 3. In short, the trajectories of the FEER would be derived from the changes in the real effective exchange rates that ensure domestic and foreign output to be in their paths to achieve the targeted current account balance This exchange rate concept is denoted as "fundamental" in that it abstracts from short-term factors and emphasizes instead determinants that are important over the medium term. An assessment of a country's exchange rate can be made by comparing its current level with the calculated FEER. The exchange rate under this approach remains unchanged as long as the positions of internal and external balance are undisturbed, but it is not clear whether the exchange rate will be in equilibrium in a behavioural sense, i.e., reflects the effect of factors that determine the exchange rate over the medium term. It is assumed that internal balance is achieved when external balance is achieved.

The first is to identify the external balance equation by simply equating the current account balance (CA) to capital account balance (KA). CA=-KA (5)

14

Following a standard definition, the current account is a sum of net trade balance and returns of net foreign assets (nfar). The net trade balance (ntb) is assumed to be a function of full employment outputs of the local and foreign economies, i.e. ( ) d y and ( ) f y respectively, and the real effective exchange rate (q).The return of net foreign asset is also influenced by the movements of the exchange rate. An accumulation of net foreign liabilities (negative net foreign asset) will have to be financed. It will be necessary under this condition for the currency to depreciate to improve trade balance and improve the net foreign asset position. Key relationships for the FEER approach can, therefore, be encapsulated in the following equations. CA = ntb + nfa ntb = δ0+δ1q+δ2yd-+δ3yfWhere: δ1> 0, δ3 >0 and 0> δ2 nfar = f (q) (6c) (6a) (6b)

In most application of the FEER approach, the level of equilibrium capital account over the medium term (KA-) is exogenously determined. It is important to underline here that (KA-) excludes speculative capital flow. Combining Equations (5 and 6a-6c) and the basic assumptions discussed above, the following medium-term balance of payment equation can be generated. CA=f(qREER, yd- , yf- )=- KA(7)

In short, there are three vital elasticities to be calculated under the FEER approach, namely, the elasticity of the current account to domestic activity yd-, to foreign output yf- , and to the real (effective) exchange rate qFEER . Given full employment outputs of the local and foreign economies yd-, and yf- respectively, and that of medium-term equilibrium (KA-), the level of real exchange rate to be derived from Equation (6) is the FEER. Hence, the last step is to solve Equation (6) for qFEER, which will ensure that we achieve a sustainable current account or the path to achieve the “macroeconomic (internal and external) balance”. qFEER=f(KA-, yd-, yf-) (8)

15

6.1 Critical Notes and Empirical Findings

Several analyses and discussions on the FEER approach are as given below. • Relying too much on the trade elasticity may generate an inaccurate estimate of the FEER trajectory. A depreciation of the real exchange rate of the domestic currency would not only lead to an improvement in (ntb) , but also should increase (nfar) . If the FEER only captures the changes in (ntb) and assume the impact on (nfar) to be exogenously determined, then the size of required real exchange rate appreciation may be overestimated. Hence the size of currency misalignment estimated by FEER is likely to be an inaccurate one. • Bayoumi (1994) and Driver and Westaway (2004) further highlighted the analytical limitation introduced into the FEER due to possible fluctuations on the returns of net foreign assets. Assume that in the initial period the current exchange is at the FEER level and internal and external balances are obtained. The actual exchange rate then depreciates in the next period, thereby improving the current balance and improving the net foreign asset position. The latter, in turn, implies that in future periods, the real exchange rate which is consistent with medium-run capital accumulation will no longer be the FEER; in particular, the FEER needs to appreciate to squeeze out the effects of net accumulation. • Given its strong set of basic assumptions (some of which are highlighted above), WrenLewis (1992) notes that the FEER is „a method of calculation of real exchange rate which is consistent with medium-term macroeconomic equilibrium‟. That is to imply that the FEER approach does not embody a theory of exchange rate determination. It is assumed that a divergence of the prevailing exchange rate from the FEER will set in motion forces that will bring the spot rate to the FEER. The approach used in the estimation of the FEER provides us with a medium-run equilibrium rate. However, the nature of the convergence process from the short-run/actual rate to the equilibrium rate is not specified (MacDonald (2000)). We will look into this issue of „transition‟ and „moving equilibrium‟ concepts when we examine the Behavioral Equilibrium Exchange Rate (BEER) and the Natural Rate of Exchange (NATREX) models. In April 2011 most currencies appear to have been reasonably close to their FEERs. The most important exceptions are China, on the weak side, and the United States, on the strong side.

16

TABLE 2: FEER ESTIMATED OVER THE 4 YEARS (2008 = 100)

17

The FEER calculated in the above table was developed by Cline in 2008.He developed a symmetric matrix inversion method model to calculate FEERs for 30 economies. This method is symmetric in that it gives equal weight to each country in arriving at the realignment to FEERs, rather than (as in Cline 2007) requiring exact achievement of the adjustment target for the United States and then solving for partner exchange rate changes that would be both broadly consistent with this requirement and roughly consistent with the other current account targets.

7. NATREX

NATREX stands for Natural Real Exchange rate In the long-run, the NATREX converges to a static long-run rate. This constant or stationary long-run real equilibrium NATREX is consistent with the PPP rate. Hence, the NATREX extends early models such as the PPP and the FEER by focusing its analyses on the periods when the fundamentals are not stationary and generating the trajectories of the exchange rate from the short term to the medium-run, and from the medium-run to the static long-run position. To illustrate the directions of the trajectories, let us consider the impact of an increase in government expenditure (social preference) in the medium-and long term horizon. In the medium-run, the rise in government expenditure will increase aggregate demand, and cause an appreciation of the real exchange rate of the local currency. The strengthening of the local currency would, in turn, worsen the current account position through a possible deterioration in the net interest flows on foreign debt. In the long-run, a depreciation of the local currency is needed to stabilize net foreign assets. In contrast to the FEER, the NATREX is a positive conception. It is the equilibrium real exchange rate which is determined by real fundamental factors and existing macroeconomic policies. These policies do not need to be optimal, and the NATREX therefore does not need to be the optimal real exchange rate from a societal point of view. The NATREX is a moving equilibrium exchange rate, and the trajectory of the exchange rate can be decomposed into three components: the medium-run, the longer-run, and the steady state. On the contrary, the FEER is based on the modeling of the current account with the intention of identifying the statistically consistent relationship between the current account and the real exchange rate.

18

The NATREX is concentrated on the change of savings, investment and long-term capital flows, and then causes changes in physical capital stocks, foreign debt and wealth to show up in the changes in the fluctuating equilibrium real exchange rate Since it is an equilibrium concept, the NATREX should guarantee both the internal and the external equilibrium, the focus being on the long run. The long-run internal equilibrium is achieved when the economy is at capacity output that is when the GNP is at its potential level. The long-run external equilibrium is achieved when the long term accounts of the balance of payments are in equilibrium. Short term (speculative) capital movements and movements in official reserves are bound to be short term transactions, since they are unsustainable in the long run. In the long-run equilibrium they must average out at zero; hence, the excess of national (private plus public) investment over national saving must be entirely financed through international long term borrowing. Under these conditions long term capital inflows and excess national investment over saving coincide, so that also the real market long-run equilibrium condition and the long-term external equilibrium condition coincide: S-I=CA [9]

(I) is the desired investment, (S) denote the desired saving and (CA) is the desired current account. Equation above captures the medium-run equilibrium when the economy is operating at capacity output and expectations about inflation are met ,similar to that of the FEER approach. Equation above also captures the balance of payment equilibrium (the sum of capital and current account balance). Relation [9] is intended in real terms: the model assumes neutrality of money and that the monetary policy keeps inflation at a level compatible with internal equilibrium (at least in the long run). Therefore, the focus being on the real part of the economy, there is no need to model the money market. Intended investments and savings (which are independent of the real exchange rate) are connected with the existing stock of capital, net debt towards foreign countries and wealth. Investment (I), savings (S) and net capital flows (I - S) produce changes in the stock of physical capital (k), net foreign debt (F) and wealth (W = k - F). These changes then change intended savings, investment and the current account. All of these, in turn, have an impact on changes in the real exchange rate.

19

The NATREX is the function of the exogenous (Z) and endogenous (X) determinants at all point other than the long term equilibrium. The complete model of the NATREX determines the medium-term equilibrium real exchange rate (R=NATREX), its consecutive trajectory and also any long-term equilibrium real exchange rate in a steady state However, the economy is permanently exposed to fundamental shocks, which direct the NATREX to a new equilibrium level, and a steady state is never reached. The NATREX is not constant but varies with "fundamentals" Z(t) which are relative productivity and relative "thrift", which is the ratio of relative consumption/GDP ratios. The actual equilibrium real exchange rate converges to the moving "equilibrium" NATREX.
7.1 Populist and Growth Scenarios

The NATREX model is a technique of analysis. The purpose of the model is to understand the effects of policies and external disturbances upon the trajectories of the equilibrium real exchange rate and equilibrium debt ratio, which depend upon the vector of fundamentals. The logic and insights of the NATREX model can be summarized in two scenarios. Each scenario concerns different elements of the fundamentals, and has different effects upon the equilibrium trajectories of the real exchange rate NATREX and of the external debt. The first scenario, called the Populist scenario, involves a decline in the ratio of social saving/GDP. This could occur when the government incurs high-employment budget deficits, lowers tax rates that raise consumption, or offers loan guarantees, subsidies for projects with low social returns. This represents rise in the consumption ratio, a decline in the saving ratio. These Populist expenditures are designed to raise the standards of consumption, quality of life for the present generation. The second scenario, called the Growth scenario, involves policies designed to raise the productivity of capital. Policies that come to mind involve the liberalization of the economy, increased competition, wage and price flexibility, and the deregulation of financial markets, improved intermediation process between savers and investors, and an honest and objective judicial system that enforces contracts. Growth policies improve the allocation of resources and bring the economy closer to the boundary of an expanding production possibility curve.

The Populist scenario involves increases in social (public plus private) consumption relative to the GDP. External borrowing must finance the difference between investment and saving. The capital inflow appreciates the real exchange rate from initial level R(0) to medium run equilibrium R(1), where T = 1 denotes medium run equilibrium. The current account deficit is balanced by the capital inflow and the debt rises. Current account deficits lead to growing transfer payments rtFt. This Populist scenario is potentially dynamically unstable because the

20

increased debt raises the current account deficit, which then increases the debt further. The exchange rate depreciates, and the debt rises, steadily. Stability can only occur if the rise in the debt, which lowers net worth equal to capital less debt, reduces social consumption/raises social saving. For example, the growing debt and depreciating exchange rate force the government to decrease the high employment budget deficit. Thereby, saving less investment rises. Long-run equilibrium (denoted by T = 2) is reached at a higher debt F (2) > F (0) and a depreciated real exchange rate R (2) < R (0). The longer-run depreciation of the exchange rate R (2) < R (0). The debt is higher than initially. Therefore, the trade balance B(2) must be higher than initially to generate the foreign exchange to service the higher transfers r(t)F(2). The real exchange rate must depreciate to R (2) < R (0) in order to raise the trade balance to B(2).

7.2 NATREX dynamics of exchange rate and external debt:

Two Basic Scenarios

R = real exchange rate (rise is appreciation), F = external debt/GDP; Initial period T = 0, medium run T=1, long-run T=2. Medium-run, T = 1 Longer-run T = 2 Populist: Rise in social in social consumption (discount rate, time preference), rise in high employment government budget deficit, decline social saving R(1) > R(0) appreciation Debt rises F(1) > F(0) R(2) < R(0) < R(1) depreciation Debt rises F(2) > F(1) > F(0) Growth oriented: Rise in productivity of investment, expansion of production possibility set. Rise in growth, rise in competitiveness appreciation R(1) > R(0) Debt rises F(1) > F(0) appreciation R(2) > R(1) > R(0) Debt declines F(2) < F(0) < F(1) The perturbation is a rise in the productivity of investment and an expansion of the production possibility set. Investment rises because of the rise in the rate of return. The difference between investment and saving is financed by a capital inflow. The exchange rate appreciates to R (1) > R (0) which reduces the trade balance and produces a current account deficit. The initial current account deficit raises the debt. The trade deficit provides the resources to finance capital formation, which raises the growth rate and the competitiveness of the economy.

21

It does not matter much where the rise in the return on investment occurred or what factors led to an expansion of the production possibility set. If they are in the traditional export or import competing sectors, the trade balance increases with a rise in the overall productivity of the economy. The trajectory to longer-run equilibrium differs from that in the Populist scenario. The crucial aspect implied by the Growth Scenario is that, at medium run equilibrium exchange rate R(1), the trade balance function increases. The real exchange rate appreciates and there are now current account surpluses, excess of saving over investment. As a result, the debt then declines to a new equilibrium F (2) < F (0). The trajectory of the debt is not monotonic. The real exchange rate appreciates steadily to a higher level R (2) > R (1) > R (0). The external debt reaches a maximum and then declines to F (2) < F (0) < F (1).

8. Overshooting Model

The Overshooting Model or Exchange rate overshooting, first developed by economist Rudi Dornbusch, aims to explain why exchange rates have a high variance. A key element of the model is that expectations of exchange rate changes are "consistent" that is, rational rather than static. The most important insight of the model is that adjustment lags in some parts of the economy can induce compensating volatility in others; specifically, when an exogenous variable changes, the short-run affect on the exchange rate can be greater than the long-run effect, so that in the short run the exchange rate overshoots its new long-run value.
8.1 Exchange rate overshooting

A basic proposition in monetary theory called monetary neutrality states that in the long run a onetime percentage rise in the money supply is matched by the same onetime percentage rise in the price level, leaving unchanged the real money supply and all other economic variables such as interest rates. An intuitive way to understand this proposition is to think of what happen if US government announced overnight that an old dollar would now be worth 100 new dollars. The money supply in new dollars would be 100 times its old value and the price level would also be 100 times higher, but nothing in the economy would really have changed; interest rates and the real money supply would remain the same. Monetary neutrality tells us that in the long run, the rise in the money supply would not lead to a change in the domestic interest rate and so it would return to iD1 in the long run, and the schedule for the expected return on domestic deposits would return to RD1. As we can see in figure, this means that the exchange rate would rise from E2 to E3 in the long run.

22

The phenomenon described here in which the exchange rate falls more in the short run than it does in the long run when the money supply increases is called exchange rate overshooting. Another way of thinking about why exchange rate overshooting occurs is to recognize that when the domestic interest rate falls in the short run, equilibrium in the foreign exchange market means that the expected return on foreign deposits must be lower. With the foreign interest rate given, this lower expected return on foreign deposits means that there must be an expected appreciation of the dollar ( depreciation of the euro) in order for the expected return on foreign deposits to decline when the domestic interest rate falls. This can occur only if the current exchange rate falls below its long run value.

9. Conclusion

This paper determines the various equilibrium exchange rates models which are used by various countries. We have explained the analytical approach for calculating the exchange rates using the parameters available. Clearly there is no single definitive model; each has its strengths and weaknesses and results could vary depending on the model used. We briefly explained the traditional model of PPP which uses the Law of one price method. We also tried to explain the Real exchange rate and the Fundamental equilibrium exchange rate along with NATREX which is widely used methods for calculating the exchange rates in most of the countries throughout the world. In the end we have described Overshooting model to study the high variance of exchange rates in short run and how it stabilizes in the long run.

23

References

1. http://www.tcmb.gov.tr/research/work/wpaper9.pdf 2. http://www.ssrn.com/ 3. http://en.wikipedia.org/wiki/Overshooting_model 4. http://www.rbi.org.in/scripts/AnnualReportPublications.aspx?Id=1024 5. http://openlib.org/home/ila/PDFDOCS/PatnaikPauly2001_indianforex.pdf 6. http://www.imf.org/external/np/speeches/2001/112901.HTM 7.http://doc.research-and analytics.csfb.com/docView?language=ENG&format=PDF&document_id=868383151&source_id=em&serialid =iXsC4IH%2B7GFcH%2FLMGJs7U2uhJN9ipyNfiCwC%2BYrCvHk%3D 8. http://www.thefullwiki.org/NATREX 9. http://www.iie.com/publications/pb/pb11-05.pdf 10. http://forex-exchange-rates.com/study-fundamental-equilibrium-exchange.html 11. Financial Markets+Institutions By Frederic S. Mishkin and Stanley G. Eakins 12. http://www.bankofengland.co.uk/publications/workingpapers/wp248.pdf 13. http://www.nber.org/papers/w11521 14. http://diplomovka.sme.sk/zdroj/3117.pdf 15. http://www.allbankingsolutions.com/neer-reer.htm 16. http://www.bundesbank.de/download/volkswirtschaft/dkp/2000/200003dkp.pdf 17. http://www.imf.org/external/pubs/ft/wp/2007/wp07155.pdf 18. http://www.seacen.org/GUI/pdf/publications/staff_paper/2011/SP81.pdf

24

About the Authors: Kuldeep Joshi: I have completed my B.Tech in IT from College of Engineering Pune. Worked as a Senior Software Engineer in CAPGEMINI for 20 months. I have worked on JAVA and tools like Xenos, OnDemand etc. HSBC North America was my client and I have worked on 3 various projects. I had regular client interaction and it was a very good experience. I have completed 2 Java certifications (SCJP, SCWCD) and 3 NCFM certifications. I was also part of the 79th REGATTA in Graduation. I like travelling and cycling. I am trading in equity markets since 2 years. At present doing a project in college on virtual biscuit industry and have successfully completed a market research project on a MBA centric magazine.

Swapnil Rathi: I have completed my BE in Computer Science and Engg from Government College of Engineering Aurangabad. Worked as a Software Engineer with HSBC Software Development India Pvt Limited Pune for 35 months. I have worked on .Net, Peoplesoft and various tools like Qstat. I was also part of Wings 08, a National level technical fest during my Graduation. I like reading and listening to music. I have been trading in equity and mutual funds since last 2 years. At present doing a project in college on a virtual Bread manufacturing industry and have successfully completed a market research project on Consumer buying behaviour of Formals apparels.

25