Concepts of equilibrium exchange rates

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 31 December 2004

Working Paper No. 248 
By Rebecca L Driver and Peter F Westaway

This paper explains what is meant by the concept of equilibrium exchange rates. It argues that a variety of equilibrium exchange rates can be defined and their behaviour will vary according to different definitions of the exchange rate, and over short, medium and long-term horizons. It emphasises that the relevance of each type will depend on the question at hand.

The behaviour of different measures of the equilibrium exchange rate is explained with reference to a range of theoretical models. The paper explicitly addresses the circumstances under which purchasing power parity, a commonly adopted benchmark for long-run exchange rate movements, is appropriate.

The most important purpose of the paper is to provide a taxonomy of the different empirical measures of equilibrium exchange rates that have been derived in the literature. It offers a comprehensive guide to the bewildering array of related acronyms that has sprung up and explains the different contexts in which different equilibrium measures might prove informative.

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