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Estimating the Equilibrium Effective Exchange Rate for Potential EMU Members

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Abstract

In this study, we attempt to examine the possibility of emergence of significant fluctuations of the exchange rates in the future for the candidate EMU countries. In doing so, we estimate the equilibrium rate of the nominal effective exchange rate for Poland, Hungary, Slovak Republic and Malta through the BEER and PEER approaches. While the PEER-based estimation implies a large misalignment rate for the Hungarian forint, the BEER-based analysis shows that the present exchange rates of the countries considered do not deviate significantly from their equilibrium rates. As a consequence, based on BEER analysis, we do not expect large fluctuations in the effective exchange rates among the currencies considered. Hence, the relevant effective exchange rates are expected to be relatively stable. As a matter of fact, the entry of those countries into EMU is not expected to weaken the stability of Euro.

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Notes

  1. On January 1, 2007, Slovenia adopted the Euro.

  2. In this study we examine nominal effective exchange rates. However, the Maastricht exchange rate criterion does not deal with effective exchange rates. A successful entry into EMU requires stability in the bilateral rate against Euro. We argue that an unstable effective exchange rate may entail instability in bilateral exchange rates, such as this against Euro.

  3. The Fundamental Equilibrium Exchange Rate (FEER) was originally presented by Williamson (1985). This approach indicates that the exchange rate is at its equilibrium value when satisfies the condition of simultaneous internal and external balance. In other words, the Fundamental Equilibrium Exchange Rate is the equilibrium rate that would be consistent with ideal macroeconomic performance.

  4. The Deutsche mark is used as a proxy of Euro until 1999.

  5. This study examines the Czech crown/Deutsche mark rate by the NATREX approach, presented by Stein (1994). This rate is consistent with simultaneous internal and external balance and equates the sustainable current account with saving and investment.

  6. Clark and MacDonald (1998) and MacDonald (2000) assume that in the UIP condition a risk premium is included. This has a time-varying component, which reflects the relative supply of domestic to foreign debt. Here, due to lack of data availability we assume that the risk premium is equal to zero.

  7. A lot of criticism has been applied to the statistical properties of the H–P filter. One of the discussed issues is its poor performance near the end of the sample. Mise et. al. (2005), Kaiser and Maravall (1999) and Baxter and King (1999) provide evidence of suboptimal H–P filtering at the endpoints. To avoid this inconsistency, following Kaiser and Maravall (1999), we estimate optimal ARIMA forecasts and we apply the H–P filter to the extended series. As noted by Mise et. al. (2005), this approach minimizes revision standard deviation.

  8. Other studies use the Univariate and Multivariate Beveridge and Nelson (1995) Decomposition. This methodology entails the direct decomposition of the exchange rate into permanent and transitory components. Some of these studies are Huizinga (1987) and Cumby and Huizinga (1990). A different way of measuring PEERs is that proposed by Clarida and Gali (1994). They decompose the real exchange rate into supply, demand and nominal components and test the importance of these variables to the exchange rate. In other words, they create three shocks (supply, demand and nominal) and examine the effects of each shock to the variability of the exchange rate. Moreover, two of the studies, which applied the Gonlzalo–Granger approach to estimate PEERs are Clark and MacDonald (2000) and Hoffmann and MacDonald (2000).

  9. Since a VAR model is valid only when stationary variables are included, we regress VAR models in an error correction form by using the first differences of the variables. Robustness of the corresponding VEC models is confirmed since the residuals are non-autocorrelated, homoskedastic and normally distributed in each of the estimated models. Diagnostics’ tests are available on request.

  10. We test the restricted against the less restricted model using their computed trace statistics. These tests follow the X 2 distribution and the degrees of freedom are as shown below: \( 1 \sim 2{\left( {r\,{\text{d}}{\text{.f}}{\text{.}}} \right)},2 \sim 3{\left( {p - r\,{\text{d}}{\text{.f}}{\text{.}}} \right)},3 \sim 4{\left( {r\,{\text{d}}{\text{.f}}{\text{.}}} \right)},4 \sim 5{\left( {p - r\,{\text{d}}{\text{.f}}{\text{.}}} \right)} \) where r is the number of cointegrated vectors and p is the number of parameters.

  11. This test’s output is available on request.

  12. Based on the money multiplier theory, the amount of money (coins & notes) held by domestic residents, decreases. Since the monetary base (H) is equal to the sum of bank reserves (R) plus coins & notes held by domestic residents \( {\left( P \right)}{\left[ {H = R + P} \right]} \), monetary base declines. Thus, domestic money supply declines as well because money supply is equal to monetary base multiplied by the money multiplier. However, this holds only if the purchase of foreign bonds is financed by coins and notes. In case of an exchange between domestic and foreign bonds, monetary base remains unaffected.

  13. The robustness of this decomposition is confirmed because the summation of the permanent and the transitory components yields to unity. The estimation procedure is not presented here to save space. However, the analytical decomposition is available on request.

  14. See footnote 13.

  15. About the 78% of the foreign asset movements are permanent and only the 26% of the oil price fluctuation is permanent. To find more, see footnote 13.

  16. National Bank of Slovakia was fixing exchange rates of selected currencies during the period 1993–1998. Slovak crown was pegged on a basket of two currencies (60% of Deutsche mark and 40% of US dollar), and it was allowed to fluctuate by no more than 7%. Since October 1998, Slovak crown is freely determined in the foreign exchange market.

  17. About the 89% of the interest rate differential, the 81% of the foreign asset holding and the 99% of the oil price movements are permanent. To find more, see footnote 13.

  18. This finding should worry us about robustness of the trend-cycle decomposition. This is not a panacea, since alternative procedures can lead to different, and in some cases contradictory, estimates.

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Acknowledgements

We are grateful to Professor Zisimos Koustas for helpful comments on a previous draft of the paper. We also thank Dr. Minoas Koukouritakis for his assistance in computational methods. Of course, we are alone responsible for any remaining errors.

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  1. Department of Economics, University of Crete, Rethymnon, 74100, Greece

    Nikolaos Giannellis & Athanasios P. Papadopoulos

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  1. Nikolaos Giannellis
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  2. Athanasios P. Papadopoulos
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Correspondence to Nikolaos Giannellis.

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Giannellis, N., Papadopoulos, A.P. Estimating the Equilibrium Effective Exchange Rate for Potential EMU Members. Open Econ Rev 18, 307–326 (2007). https://doi.org/10.1007/s11079-007-9040-x

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