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 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

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

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)

Trade, capital flows and ER in Croatia

Index of Real Exchange Rate

Nominal ER of Euro and USD

PPI for Croatia, EU, and relative PPI

Construction on IREER

Export of goods and services

Imports of goods and services

Destination of exports

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

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)

Estimating FEER

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

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.

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

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...

Estimate Trade balance and elasticities of imports and exports relative to the exogenous variables

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

Estimate X and M equations… DLOG(X) = *LOG(RER) *DLOG(M*(-1)) *DLOG(M) (-2.18) (2.12) (5.01) (12.16) R 2 =0.79F-stat=53.9 DLOG(M) = *DLOG(Y) *LOG(RER) (0.30) (4.18) (-0.29) R 2 =0.27F-stat=8.54

Actual REER and FEER

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)