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Equilibrium Exchange Rates

Some History

I first began working in this area with Ray Barrell (see Barrell and Wren-Lewis, 1989), as a key input into assessing John Williamson and Marcus Miller's proposal for international policy cooperation (see Currie and Wren-Lewis (1989) and other papers with David Currie in my CV). In 1990, together with colleagues at NIESR, I used this framework to argue that 2.95 DM/£ was too high an exchange rate to enter the ERM, and that entering at this rate could intensify and prolong the emerging recession. (see Wren-Lewis et al (1991)). For an analysis of the benefits of abandoning this parity in 1992, see Hughes Hallett and Wren-Lewis (1997). 

An Alternative to PPP

The most widely used method of computing equilibrium exchange rates is Purchasing Power Parity. There are a number of powerful theoretical reasons to doubt the validity of PPP over a medium term time horizon (see Wren-Lewis (2003a) for example). The 'new international macroeconomics' explores a world in which international trade involves differentiated products sold in imperfectly competitive markets, where the terms of trade are influenced by macroeconomic factors such as idosyncratic productivity shocks. In Wren-Lewis (2004) I argue that John Williamson's FEER approach fits naturally into this framework. In Barisone, Driver and Wren-Lewis (2006) we argue that this approach to assessing equilibrium rates is more powerful than PPP in explaining past movement in G7 parities. 

A Sterling Euro Entry Rate

In 2002 I was asked by H.M.Treasury to write a survey of work on equilibrium exchange rates for Sterling and the Euro, and subsequently to calculate a new estimate of my own. The paper (Wren-Lewis (2003a)) was published as part of the Treasury's analysis of its Five Tests for Euro entry. This work was completed in the summer of 2002, when the Euro Sterling rate was above 1.6, and had been for some time. The estimate I made then of an equilibrium rate of around 1.37 Euro/Sterling seems less heroic today! The Euro has also appreciated, and the dollar depreciated, to move past my estimate of an equilibrium $/Euro rate of 1.15. These calculations were produced using a new model (FABEER) involving four main country blocs. Details of the model are contained in the paper.

The paper compares these new estimates with some other recent alternative approaches, and also with my earlier work with Rebecca Driver in Driver and Wren-Lewis (1998) published by the PIIE in Washington. 

Latest Estimates

Detailed estimates for the US dollar, the Yen, the Euro and Sterling based on the FABEER model are contained in Wren-Lewis, 2004, a paper given in May 2004 to a conference organised by the PIIE in Washington DC, and now published as a book. The paper also contains some discussion of China's Renminbi. The paper uses the FABEER model, which was the basis of my analysis for the UK Treasury of the equilibrium Sterling Euro rate. These are updated in Wren-Lewis, 2007 (bookearlier version), although as the title of this paper suggests, the main focus here is on the implications of alternative paths for US savings behaviour. 

One of the drawbacks of the partial equilibrium FEER approach to calculating equilibrium rates is that 'sustainable' current accounts are exogenous inputs. Wren-Lewis, 2004 presents an initial attempt at transforming the partial equilibrium FABEER model into a general equilibrium model. The model is used to examine two particular US shocks: a technology shock and a fiscal shock. (For an earlier discussion using a calibrated small open economy macromodel, see Wren-Lewis, 2003b).

In Wren-Lewis (2004b) I adapt the FABEER model to analyse equilibrium values for the New Zealand and Australian dollars. Both currencies are highly dependent on movements in commodity prices, and both currencies experienced strong appreciations in 2003. 


Barisone, G., Driver, R.L. and Wren-Lewis, S (2006) Are Our FEERs Justified? Journal of International Money and Finance 25, 741-759

Barrell, R and Wren-Lewis, S (1989) Fundamental Equilibrium Exchange Rates for the G7, CEPR Discussion Paper 323

Currie, D. and Wren-Lewis, S. (1989), Evaluating blueprints for the conduct of international macropolicy, American Economic Review, 79,264-269

Driver, R and Wren-Lewis, S (1998), Exchange Rates for the Year 2000, in , ed(s), International Institute for International Economics, Washington

Hughes Hallet, A. and Wren-Lewis, S. (1997), Is There Life Outside the ERM? An Evaluation of the Effects of Sterling's Devaluation on the UK Economy, International Journal of Finance and Economics, 2,199-216

Wren-Lewis, S., P. Westaway, S. Soteri and R. Barrell (1991), Evaluating the UK's Choice of Entry Rate into the ERM, Manchester School Money Study Group Conference Volume., 59,1-22

Wren-Lewis, S (2003a), Estimates of Equilibrium Exchange Rates for Sterling against the Euro, H.M.Treasury

Wren-Lewis, S. (2003b), Medium Term Exchange Rate Dynamics

Wren-Lewis, S (2004), The Needed Changes in Bilateral Exchange Rates, in Bergsten, C.F. and Williamson, J (2004), Dollar Adjustment: How Far? Against What? Institute of International Economics, Washington DC.

Wren-Lewis, S (2004b), A model of Equilibrium Exchange Rates for the New Zealand and Australian Dollars, Reserve Bank of New Zealand Discussion Paper DP2004/07

Wren-Lewis, S (2007), When the Dollar Falls, in Quantitative Economic Policy: Essays in Honour of Andrew Hughes Hallett, eds Neck, R, Richter, C and Mooslechner,P, Springer. (book, earlier version)
Simon Wren-Lewis,
Aug 17, 2012, 9:49 AM