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All models to measure equilibrium exchange rates have flaws, but two of the best both signalled that the dollar was significantly overvalued in 2006, according to an IMF working paper released on Friday.
A core mission of the International Monetary Fund is to judge when exchange rates are misaligned, because this can provoke a currency crisis and lead to major economic costs.
To do this the IMF uses models to assess equilibrium exchange rates based on purchasing power parity (PPP), or newer tests that weigh macroeconomic balances like the current account.
"The assessment of equilibrium exchange rates requires considerable judgement, and ... policy-makers, ideally, should inform their judgements through the application of several different methodologies," wrote the author, Peter Isard.
Purchasing power parity, based on the idea that nominal exchange rates move in line with national price levels, has been around for years. But it is subject to many pitfalls, including the choice of price index.
Getting this wrong can have serious consequences, which Winston Churchill found out the hard way in 1925 when, as finance minister, he took Britain back onto the gold standard at its inflated pre-World War One rate against the dollar.
Economist John Maynard Keynes, using a different price index, argued the pound was overvalued by 12 percent. He lost the argument and Britain's return to the gold standard contributed to the Great Depression.
With this and other health warnings in mind, Isard took four different PPP-based models and two variations of the macroeconomic balance approach and applied them to the dollar in 2006.
The macroeconomic balances-based models both found the real effective exchange rate of the dollar to be either 20 or 25 percent overvalued, while the PPP-based models all agreed it was reasonably in line.
The dollar slipped to record lows against the euro and pound this year as the slumping US housing sector hit growth and sparked a global credit crunch, forcing the Federal Reserve to cut interest rates by a percentage point.
Isard favoured the macroeconomic balance approach because he felt it was easier to explain to policy-makers and the general public, and hence stood a better chance of convincing them of the need to take potentially painful policy measures.
There were also considerable costs associated with having a persistently undervalued exchange rate, he noted. It inflates the profitability of a country's export sector and leads to the misallocation of investments, to the detriment of the domestic economy. China springs to mind, and the IMF has indeed urged Beijing allow its yuan currency to appreciate.
The IMF paper also acknowledged that there were problems in using the macroeconomic balances approach for big countries with bright growth prospects.
They might draw strong capital inflows causing a current account deficit. But such investments also lift productivity and output, which ought to trim the current account over time.

Copyright Reuters, 2007

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