In Discussion Paper No. 323, Ray Barrell and Research Fellow Simon Wren-Lewis outline a small model to provide estimates for FEERs for the G7 countries from 1971 to 1988, and compare them to the actual paths of exchange rates over that period. They use econometric estimates embodied in the National Institute's Global Econometric Model for income and price elasticities for trade in goods and services and for the relationships determining the influence of world prices on each country's export and import prices.
Barrell and Wren-Lewis use these estimates, along with trends derived from the trade accounts of the G7 countries over the period 1970-88, to estimate the relationship between the current account and the real exchange rate. The observed current account depends on actual and past values of the factors affecting trade in goods and services, such as the real exchange rate, world income, domestic income and real commodity prices. The authors allow for the potential dependence of the natural rate of unemployment on the real exchange rate and also take into account the influence on the trend current account of income flows from overseas assets and liabilities.
The trend current account relationship produces many possible paths for the real exchange rate, but the FEER is the only one of these which is consistent with the level of `structural' capital flows (or equivalently, non-speculative flows) that will take place in equilibrium. Barrell and Wren-Lewis's definition of structural capital flows includes those flows that reflect long-term international profitability differentials or changing portfolio preferences, but not interest rate differentials or expectations of short-term exchange rate changes. Their analysis therefore focuses on the medium- and long-term path of the exchange rate.
FEERs may well vary over time, the authors note, not only because the structural capital flows change, but also because of divergent trends in the trade and output characteristics of the economies involved. They conduct an empirical analysis incorporating alternative assumptions about exogenous variables and possible structural shifts in trade relationships. The calculations strongly suggest that FEERs may lie within quite wide ranges of possible values.
The authors' model provides estimates that the US FEER lies in a range from 5 to 15% below the actual value of the dollar in the first quarter of 1989. In fact, an even larger range for the dollar may be prudent, partly because of the unusually high and unexplained level of US imports over the last three years. The FEER for the yen represents an appreciation of between 5 and 15%, with the major uncertainty here resulting from the structural outflow of Japanese capital. The FEER for the Deutschmark is 7-17% above its current level. Finally, Barrell and Wren-Lewis estimate that a large part of the UK current account deficit in mid-1988 reflected excess demand, and the remainder an overvaluation of sterling relative to its FEER of between 0 and 10%.

Fundamental Equilibrium Exchange Rates for the G7
Ray Barrell and Simon Wren-Lewis

Discussion Paper No. 323, June 1989 (IM)