ABSTRACT
This chapter sets out to examine the concept of equilibrium exchange rates. Empirical estimates of equilibrium exchange rates are frequently cited in policy-related discussions of the international conjuncture, not only by academics (see Williamson 1993; Wren-Lewis et al. 1991) but also by policy institutions. Such estimates are found to be useful for various closely related reasons:
It is useful to know where current exchange rates stand relative to longer-term measures of equilibrium, as these may provide some information on likely future movements in exchange rates.
In the context of fixed exchange rate arrangements, in particular monetary union, it is important to know whether a particular entry rate will be costly to sustain or whether subsequent adjustment of relative inflation rates will be necessary to justify any nominal exchange rate peg.
When interpreting economic out turns, it is useful to know whether an observed change in the value of exchange rate is justified by perceived shocks to the macroeconomic environment. Different shocks can have very different implications for the outlook, especially so in open economies such as the UK where terms of trade effects can have significant implications for inflation outcomes. Therefore knowing which is the most likely shock to account for observed exchange rate movements may help to determine the best policy response.
