1. Why Real Exchange Rates?

Luis A.V. Catão

How does one determine whether a currency is fundamentally undervalued or overvalued?

This question lies at the core of international economics, many trade disputes, and the new
IMF surveillance effort.

George Soros had the answer once—in 1992—when he successfully bet $1 billion against
the pound sterling, in what turned out to be the beginning of a new era in large-scale currency
speculation. Under assault by Soros and other speculators, who believed that the pound was
overvalued, the British currency crashed, in turn forcing the United Kingdom's dramatic exit
from the European Exchange Rate Mechanism (ERM), the precursor to the common
European currency, the euro, to which it never returned.

But in the ensuing years, neither Soros nor fellow speculators have repeated the feat
consistently, and the economics profession itself lacks a foolproof method of establishing
when a currency is properly valued. This failure is striking given that the exchange rate is a
central price in economics and that there is a measure potentially capable of delivering the
answer and for which plenty of data exist: the real exchange rate (RER).

What things really cost

Most people are familiar with the nominal exchange rate, the price of one currency in terms
of another. It's usually expressed as the domestic price of the foreign currency. So if it costs
a U.S. dollar holder $1.36 to buy one euro, from a euro holder's perspective the nominal rate
is 0.735. But the nominal exchange rate isn't the whole story. The person, or firm, who buys
another currency is interested in what can be bought with it. Are they better off with dollars
or euros? That's where the RER comes in. It seeks to measure the value of a country's goods
against those of another country, a group of countries, or the rest of the world, at the prevailing
nominal exchange rate.

One can measure the real exchange rate between two countries in terms of a single
representative good—say, the Big Mac, the McDonald's sandwich of which a virtually
identical version is sold in many countries. If the real exchange rate is 1, the burger would
cost the same in the United States as in, say, Germany, when the price is expressed in a
common currency. That would be the case if the Big Mac costs $1.36 in the United States
and 1 euro in Germany. In this one-product world (in which the prices equal the exchange
rates), the purchasing power parity (PPP) of the dollar and the euro is the same and the RER
is 1 (see box). In this case, economists say that absolute PPP holds.
 What is the real exchange rate?

The RER between two currencies is the product of the nominal

exchange rate (the dollar cost of a euro, for example) and the ratio of
prices between the two countries. The core equation is RER=eP*/P,
where, in our example, e is the nominal dollar-euro exchange
rate, P* is the average price of a good in the euro area, and P is the
average price of the good in the United States.

In the Big Mac example, e = 1.36. If the German price is 2.5 euros
and the U.S. price is $3.40, then (1.36) x (2.5) ÷ 3.40 yields an RER
of 1. But if the German price were 3 euros and the U.S. price $3.40,
then the RER would be 1.36 x 3 ÷ 3.40 = 1.2.

But suppose the burger sells for 1.2 euros in Germany. That would mean it costs 20 percent
more in the euro area, suggesting that the euro is 20 percent overvalued relative to the dollar.
If the real exchange rate is out of whack, as it is when the cost is 1.2, there will be pressure
on the nominal exchange rate to adjust, because the same good can be purchased more
cheaply in one country than in the other. It would make economic sense to buy dollars, use
them to buy Big Macs in the United States at the equivalent of 1 euro, and sell them in
Germany for 1.2 euros. Taking advantage of such price differentials is called arbitrage. As
arbitrageurs buy dollars to purchase Big Macs to sell in Germany, demand for dollars will
rise, as will its nominal exchange rate, until the price in Germany and the United States is the
same—the RER returns to 1.

In the real world, there are many costs that get in the way of a straight price comparison—
such as transportation costs and trade barriers. But the fundamental notion is that when RERs
diverge, the currencies face pressure to change. For overvalued currencies, the pressure is to
depreciate; for undervalued currencies, to appreciate. It can get more complicated if factors
such as government policies hinder normal equilibration of exchange rates, often an issue in
trade disputes.

Overvalued or undervalued?

How about comparing purchasing power when countries sell more than one product? To do
this, economists usually measure the real exchange rate in terms of a broad basket of goods.
Because the price of such a basket normally takes the form of an index number—such as the
consumer price index (CPI), which includes both goods and services—the RER is also
typically expressed as an index that can be benchmarked to any chosen time period. Going
back to the dollar-euro example, if an RER index is 1.2, the average consumer prices in
Europe are 20 percent higher than in the United States, relative to the chosen benchmark.
Indexes don't measure absolute prices (such as the price of the Big Mac), but changes in
overall prices relative to a base year (if, say, the index is 100 in the year 2000 and 120 in
2007, average prices are 20 percent higher than in 2000). In this case, if RER indexes between
countries don't change over time, we say that relative PPP holds.
RER indexes between two countries can be important. The massive U.S. trade deficit with
China has become a political and economic issue, and whether its roots are in a fundamentally
misaligned exchange rate is a point of contention.

But, for the most part, economists and policymakers are more interested in the real effective
exchange rate (REER) when measuring a currency's overall alignment. The REER is an
average of the bilateral RERs between the country and each of its trading partners, weighted
by the respective trade shares of each partner. Being an average, a country's REER may be in
"equilibrium" (display no overall misalignment) when its currency is overvalued relative to
that of one or more trading partners so long as it is undervalued relative to others.

To establish when a currency is misvalued, and, if so, by how much, a rough assessment can
be obtained by the REER series over time. Under either absolute or relative PPP, there should
be no change in REERs over time if currencies are in equilibrium. But because consumption
patterns can change faster than the market baskets statisticians construct—as can trade
policies and tariffs and transportation costs—deviations in REERs don't necessarily indicate
fundamental misalignment.

Yet, even though transportation costs and tariffs have declined sharply over the past century
and national consumption baskets have grown more uniform, fluctuations of REERs have
intensified. A century ago, among advanced economies, REER fluctuations were within a 30
percent band. In the 1980s, the United States experienced swings in its REER as wide as 80
percent! Other countries have had similar experiences.

Tough calls

But not all large REER fluctuations should be interpreted as indications of misalignment.
Some large REER adjustments are remarkably smooth, suggesting that there may be factors
besides transportation costs, tastes, and tariffs that play a key role in moving about the REER
of a currency that is not misaligned.

Technological progress leading to productivity increases in goods commonly traded, called

tradables, is thought to be one of those factors. Higher productivity lowers production costs,
thus lowering prices of such tradable goods in the higher-productivity country, which then
translates into lower tradable goods prices elsewhere through international competition. But
not all goods are tradables. Nontradable sectors, such as housing and many personal services,
face minimal international price competition. So the prices of tradable goods will tend to fall
relative to those of nontradable goods. To the extent that nontradable goods have a large
weight in the country's consumption basket, the country's consumer price index will rise
relative to the international consumer basket; hence, its REER will tend to appreciate. This
mechanism is often referred to as the "Balassa-Samuelson effect." Both theory and data
support that much of the REER variations across countries are accounted for by fluctuations
in the prices of nontradables relative to those of tradables, and particularly so among
developing countries.
Persistent changes in terms of trade (such as oil producers usually experience) and differences
in fiscal policies, tariffs, and even financial development can also help explain why REERs
can differ across countries. The IMF and economic analysts take such real exchange rate
fundamentals into account in estimating the "equilibrium" REER, around which the actual
REER should hover if there is no misalignment.

Estimating equilibrium REERs can be difficult because prices are somewhat sticky in the
short run and the nominal exchange rate is not (at least in countries where exchange rates are
market determined). So REERs typically display considerable short-run volatility in response
to news and noise trading, and it's not surprising that many market participants and
policymakers get things wrong—sometimes very wrong. That can lead to massive
realignments with devastating consequences—such as the 1992 ERM crisis. Imperfect
though they may be, REERs have signaled large exchange rate overvaluations in the run-up
to many financial crises, making it important for the IMF and others to monitor bilateral RERs
and multilateral REERs.

F&D, September 2007, IMF

2. Exchange Rate Regimes: Fix or Float?

Whether he knows it or not, the owner of a Pacific island surfboard shop thinking in March
about the cost of buying 100 surfboards from his California supplier in July should care about
his country's exchange rate regime. A country's exchange rate regime governs its exchange
rate—that is, how much its own currency is worth in terms of the currencies of other
countries. If the surfboard shop owner's country has a fixed exchange rate regime, under
which the value of the local currency is tied to that of the U.S. dollar, then he can be confident
that the price of surfboards in his currency won't change over the coming months. By contrast,
if his country has a flexible exchange rate regime vis-à-vis the U.S. dollar, then its currency
could go up or down in value during the change of seasons and he may want to allocate more,
or less, local currency for his forthcoming surfboard purchase.

If you extend the above scenario to all cross-country transactions, you can see that the
exchange rate regime has a big impact on world trade and financial flows. And the volume
of such transactions and the speed at which they are growing highlight the crucial role of the
exchange rate in today's world, thereby making the exchange rate regime a central piece of
any national economic policy framework.

Types of regimes

Exchange rate regimes are typically divided into three broad categories. At one end of the
spectrum are hard exchange rate pegs. These entail either the legally mandated use of another
country's currency (also known as full dollarization) or a legal mandate that requires the
central bank to keep foreign assets at least equal to local currency in circulation and bank
reserves (also known as a currency board). Panama, which has long used the U.S. dollar, is
an example of full dollarization, and Hong Kong SAR operates a currency board.

Hard pegs usually go hand in hand with sound fiscal and structural policies and low inflation.
They tend to remain in place for a long time, thus providing a higher degree of certainty for
pricing international transactions. However, the central bank in a country with a hard
exchange rate peg has no independent monetary policy because it has no exchange rate to
adjust and its interest rates are tied to those of the anchor-currency country.

In the middle of the spectrum are soft exchange rate pegs— that is, currencies that maintain
a stable value against an anchor currency or a composite of currencies. The exchange rate can
be pegged to the anchor within a narrow (+1 or –1 percent) or a wide (up to +30 or –30
percent) range, and, in some cases, the peg moves up or down over time—usually depending
on differences in inflation rates across countries. Costa Rica, Hungary, and China are
examples of this type of peg. Although soft pegs maintain a firm "nominal anchor" (that is, a
nominal price or quantity that serves as a target for monetary policy) to settle inflation
expectations, they allow for a limited degree of monetary policy flexibility to deal with
shocks. However, soft pegs can be vulnerable to financial crises—which can lead to a large
devaluation or even abandonment of the peg—and this type of regime tends not to be long
lasting.

At the other end of the spectrum are floating exchange rate regimes. As the name implies, the
floating exchange rate is mainly market determined. In countries that allow their exchange
rates to float, the central banks intervene (through purchases or sales of foreign currency in
exchange for local currency) mostly to limit short-term exchange rate fluctuations. However,
in a few countries (for example, New Zealand, Sweden, Iceland, the United States, and those
in the euro area), the central banks almost never intervene to manage the exchange rates.

Floating regimes offer countries the advantage of maintaining an independent monetary

policy. In such countries, the foreign exchange and other financial markets must be deep
enough to absorb shocks without large exchange rate changes. Also, financial instruments
must be available to hedge the risks posed by a fluctuating exchange rate. Almost all
advanced economies have floating regimes, as do most large emerging market countries.

Common language

Because the exchange rate regime is an important part of every country's economic and
monetary policy, policymakers need a common language for discussing exchange rate
matters. After all, an exchange rate regime that looks soft to one observer may look hard to
another—which reflects, among other things, a lack of information among different players
about foreign exchange markets and about purchases or sales of foreign exchange by central
banks.
The IMF has developed the most widely used language and terminology for classifying
exchange rate regimes, as part of its mandate to oversee the exchange rate policies of its
member countries. Historically, exchange rate regimes reported by the IMF were based on a
country's own classification, that is, a de jure regime. But starting in 1999, the IMF also began
to report de facto—that is, observed—exchange rate regimes based on the IMF staff 's
assessment of available information. And a comparison of de jure and de facto regimes shows
a fair number of discrepancies (see box).

Shifting trends

Currently, on a de facto basis, 48 countries have hard pegs, 60 countries have soft pegs, and
79 countries have floating rates—a marked change from the early 1990s. Since then, there
have been two broad trends in regimes. The first is the "hollowing out of the middle" that
started around 1990 (see chart). At the time, capital flows around the world had accelerated
in response to both the removal of capital account controls and the development of new
financial products and markets. However, inflows to many countries came to a "sudden stop,"
typically in the context of a rising current account deficit, and led to a fall in the demand for
their currencies. In some cases—particularly in Western Europe in 1992 and in East Asia
during the late 1990s—the demand fell so dramatically that countries ran out of international
reserves for defending the peg and were forced to devalue their currencies. In most cases,
they moved to either a hard peg exchange rate, which is resilient to inflows, or to a float,
which precludes the need to commit to a level of the exchange rate.

This "hollowing out of the middle" came to a halt in 2001. The period since then has seen a
more subtle shift in countries' exchange rate regime choices. Within the floating group, more
countries are now managing the exchange rate rather than floating independently, and soft
pegs have also regained some of their earlier popularity. Many countries are not able or
willing to commit to a hard peg, but neither are they able to float freely because of gaps in
financial markets and because exchange rate changes can seriously affect countries' balance
sheets, inflation, and growth. Moreover, in a number of cases, the de facto shift toward more
tightly managed regimes has occurred without a declared (de jure) change in exchange rate
policies.

What the future holds

What can be expected of exchange rate regimes in the future? One school holds that the
benefits of currency blocs—groups of countries using a single currency (probably the U.S.
dollar, the yen, or the euro)—are so overwhelming that the number of independent currencies
will inevitably dwindle, perhaps to the single digits. This would simplify cross-country
transactions but preclude each country in a bloc from operating an independent monetary and
exchange rate policy.

Another school stresses the benefits of a floating exchange rate and independent monetary
policy and predicts the continued existence of a large number of national currencies tethered
to various nominal anchors. Whether a large number of floating exchange rate currencies
remain, or whether they coalesce into a small number of bloc currencies, will have very
different implications for businesses, policymakers, and owners of surfboard shops.

F&D, March 2008, IMF

3. PPP Versus the Market: Which Weight Matters?

Tim Callen

How fast is the global economy growing? Is China contributing more to global growth than
the United States? Is the average person richer in Canada or in Switzerland? These types of
questions are of great interest to economists and others, and at first blush it appears reasonable
to assume that each has a clear-cut answer. But, as with many things in economics, the reality
is different.

To answer the questions, one must compare the value of the output from different countries.
But each country reports its data in its own currency. That means that to compare the data,
each country's statistics must be converted into a common currency. However, there are
several ways to do that conversion and each can give a markedly different answer. "Back to
Basics" explains the difference between the two main methods of making international
comparisons of economic variables.
Two different yardsticks

International financial institutions produce a wide range of regional and global statistics. The
IMF, one of these institutions, publishes many of its statistics—such as real GDP growth,
inflation, and current account balances—twice a year in its World Economic Outlook (WEO).
These statistics combine, or aggregate, the results from many countries into an average. The
importance, or weight, of an individual country's data in the overall result depends on the size
of its economy relative to the others being compared. To derive these weights, one converts
the GDP of a country in national currency terms to a common currency (in practice, the U.S.
dollar).

One of the two main methods of conversion uses market exchange rates—the rate prevailing
in the foreign exchange market (using either the rate at the end of the period or an average
over the period). The other uses the purchasing power parity (PPP) exchange rate—the rate
at which the currency of one country would have to be converted into that of another country
to buy the same amount of goods and services in each country.

To understand PPP, let's take a commonly used example, the price of a hamburger. If a
hamburger is selling in London for £2 and in New York for $4, this would imply a PPP
exchange rate of 1 pound to 2 U.S. dollars. This PPP exchange rate may well be different
from that prevailing in financial markets (so that the actual dollar cost of a hamburger in
London may be either more or less than the $4 it sells for in New York). This type of cross-
country comparison is the basis for the well-known "Big Mac" index, which is published by
the Economist magazine and calculates PPP exchange rates based on the McDonald's
sandwich that sells in nearly identical form in many countries around the world.

Of course, any meaningful comparison of prices across countries must consider a wide range
of goods and services. This is not an easy task, because of the amount of data that must be
collected and the complexities in the comparison process. To facilitate price comparisons
across countries, the International Comparisons Program (ICP) was established by the United
Nations and the University of Pennsylvania in 1968. PPPs generated by the ICP are based on
a global survey of prices. For the ongoing 2003–06 round, each of the participating countries
(about 147) provides national average prices for 1,000 closely specified products.

PPP versus market rates

So which method is better? The appropriate way to aggregate economic data across countries
depends on the issue being considered. Market exchange rates are the logical choice when
financial flows are involved. For example, the current account balance represents a flow of
financial resources across countries. It is appropriate to use the market exchange rate to
convert these flows into dollars when aggregating across regions or calculating the global
current account discrepancy. But for other variables, the decision is less clear cut. Take real
GDP growth. International organizations use different approaches. The World Bank uses
market-based rates to determine the weights in its regional and global aggregations of real
GDP, whereas the IMF and the Organization for Economic Cooperation and Development
use weights based on PPP rates (although the IMF also publishes a global growth aggregate
based on market rates in the WEO). Each methodology has its advantages and disadvantages.

Advantages of PPP. A main one is that PPP exchange rates are relatively stable over time.
By contrast, market rates are more volatile, and using them could produce quite large swings
in aggregate measures of growth even when growth rates in individual countries are stable.
Another drawback of market-based rates is that they are relevant only for internationally
traded goods. Nontraded goods and services tend to be cheaper in low-income than in high-
income countries. A haircut in New York is more expensive than in Lima; the price of a taxi
ride of the same distance is higher in Paris than in Tunis; and a ticket to a cricket game costs
more in London than in Lahore. Indeed, because wages tend to be lower in poorer countries,
and services are often relatively labor intensive, the price of a haircut in Lima is likely to be
cheaper than in New York even when the cost of making tradable goods, such as machinery,
is the same in both countries. Any analysis that fails to take into account these differences in
the prices of nontraded goods across countries will underestimate the purchasing power of
consumers in emerging market and developing countries and, consequently, their overall
welfare. For this reason, PPP is generally regarded as a better measure of overall well-being.

Drawbacks of PPP. The biggest one is that PPP is harder to measure than market-based rates.
The ICP is a huge statistical undertaking, and new price comparisons are available only at
infrequent intervals. Methodological questions have also been raised about earlier surveys.
In between survey dates, the PPP rates have to be estimated, which can introduce inaccuracies
into the measurement. Also, the ICP does not cover all countries, which means that data for
missing countries have to be estimated.

Does it make a difference?

It depends. There is a large gap between market and PPP-based rates in emerging market and
developing countries, for most of which the ratio of the market and PPP U.S. dollar exchange
rate is between 2 and 4. But for advanced countries, the market and PPP rates tend to be much
closer. As a result, developing countries get a much higher weight in aggregations that use
PPP exchange rates than they do using market exchange rates. China's weight in the global
economy is more than 15 percent using PPP exchange rates, but less than 5 percent with
market-based weights. For India, the figures are 6 percent and 1.5 percent, respectively.

Thus, the choice of weights makes a big difference in calculations of global growth, but little
difference to estimates of aggregate growth in advanced countries. The per capita income gap
between the richest and poorest countries is modestly reduced under PPP exchange rates
(although it remains exceptionally large), and some countries jump up or down the income
scale depending on the exchange rate conversion used.

So how fast is the global economy growing? Using PPP, the latest WEO estimates that global
growth was 5.1 percent in 2006, but only 3.8 percent at market rates.
Who contributes more to global growth, China or the United States? Using PPP it's China.
But using market rates, the United States wins out (see chart).

Which country is richer, Canada or Switzerland? Even among advanced countries, the
choice of weights can matter. Using market rates, per capita income in Switzerland exceeds
that in Canada, but when PPP rates are used the situation is reversed.

F&D, March 2007, IMF