Medium term exchange rates and current accounts

For teachers and students of macroeconomics

This is about how real exchange rates are determined in the medium term. So we abstract from the complications caused by sticky prices and monetary policy. However as anyone who understands uncovered interest parity knows, exchange rates in the short run depend crucially on expectations about medium term exchange rates, so the determination of medium term exchange rates is important whatever your time horizon.

The framework I use when teaching at masters level is the ‘new open economy’ (NOEM) approach, associated with Obstfeld and Rogoff in particular. A classic survey is by Philip Lane. If this framework could be summed up in one sentence, it would be this. In a world where most international trade takes place in goods sold in imperfectly competitive markets, the real exchange rate moves to equate the demand and supply for domestically produced output. [1] What follows is not about whether that framework is empirically useful, but why teaching it can avoid some confusions and pitfalls.

This concept was not of course invented by NOEM. John Williamson’s approach to determining equilibrium exchange rates, later taken up by the IMF and others, is based on the same idea. (See this earlier post for references. Williamson's work can in turn be seen as a development of the 'Swan diagram'.) Indeed I sometimes get annoyed that the NOEM literature typically ignores its antecedents. However one source for confusion is that the essentially empirical literature associated with Williamson focuses on the current account, rather than the supply and demand for domestic output. It does this because the current account is a readily available indicator of this supply and demand balance much of the time. But not always, as the following classic example shows.

Suppose an economy discovers a finite natural resource, like oil, which takes a negligible amount of labour to extract.[2] It takes a few years before the discovery leads to the resource being extracted, but the extent of the resource is common knowledge. This is a standard exercise in consumption smoothing. Consumption rises the moment the resource is discovered, anticipating higher future income. This leads to a current account deficit until the resource is extracted. Once it starts being extracted, consumers are now consuming less than their income, first to pay off their borrowing, and then to save for the day the resource runs out. So while the resource is extracted we get a current account surplus.

What happens to the real exchange rate? If we focus on the current account, we might be tempted to say that it first depreciates, and then appreciates when we have a surplus. This would be wrong. We could start with a special and highly unrealistic case, where there are no non-traded goods, the economy is so small that only a negligible amount of the additional consumption is spent on home produced goods, and labour supply is fixed. In that case nothing would happen to the real exchange rate at any time. More realistically, transport costs will mean there is some ‘home bias’ in consumption, and also some of the consumption will go on domestically produced non-traded goods. Both imply a domestic real appreciation, which begins while the current account is in deficit, and which stays the same as the current account switches to surplus.[3] In addition, if consumers want to match higher consumption with more leisure, labour supply will decrease, and we get an appreciation to choke off demand for domestically produced goods. Again this happens throughout, and not just when the resource is extracted.

The reason why looking at the current account is misleading is that we are ignoring the capital account. Before the resource is extracted, consumption rises through borrowing from abroad. If all the extra consumption is on overseas goods, those lending to consumers require no domestic currency (they can lend in dollars). But if some of the additional consumption is spent domestically, some of the lending must also be in domestic currency, so we get an appreciation. Once the resource begins to be sold (for dollars), it is as if all the extra income is used to buy overseas assets. So the size of the appreciation remains unchanged.

Thinking about both current and capital accounts in this situation is tricky, but thinking about the supply and demand for the domestically produced tradable goods gives us the same answer much more easily.

[1] In a simple model without capital, supply is just labour supply and productivity. For a small open economy where there are no non-traded goods or home bias, demand for domestically produced goods just depends on world output and competitiveness=real exchange rate. In this simple set-up a consumer price based real exchange rate is constant (PPP holds), but once we introduce realistic features like home bias or non-traded goods competitiveness influences a consumer price based real exchange rate, and PPP no longer holds.

[2] For simplicity ignore the capital required to extract the resource, and we assume all the income from the resource goes to domestic consumers.

[3] The two mechanisms work in different ways, however. The additional demand for non-traded goods takes labour away from traded goods production, so reduced traded goods supply leads to an appreciation. With home bias we get an appreciation because of the additional demand for domestically produced traded goods.

Currency Misalignments and Current Accounts

One of my favourite journal paper titles is Xavier Sala-i-Martin’s AER paper ‘I just ran two million regressions’. The problem that paper tries to deal with is that there are too many potential variables that you could conceivably put in an equation explaining differences in economic growth rates among countries. There is then a serious danger of (intentional or otherwise) data mining. A researcher may want to establish that their pet new variable is important in determining growth, so they try lots of different regressions. When one set of additional variables are included the pet new variable is significant, but when another set is used it is not. Only the first group of regressions are published. Sala-i-Martin’s paper uses techniques that involve looking at all possible permutations of variables, in order to try and assess which are robust, in the sense of tending to be significant whatever else is in the regression.  

A recent ECB working paper by Ca’Zorzi, Chudik and Dieppe does something similar with models of the medium term current account. Why is this important? In my view it’s a key ingredient in being able to say something about exchange rate misalignments. This idea is associated in particular with the work of John Williamson, who christened the approach Fundamental Equilibrium Exchange Rates, or FEER for short. (That led to probably the best title of any of the papers I have co-authored – ‘Are Our FEERs justified’ – where we test the FEER approach against PPP[1].) John’s most recent analysis, co-authored with William Cline, can be found here. This or very similar approaches often go by different names: in Peter Isard’s nice survey it is called the macroeconomic balance approach, and it continues to be used (along with other methods) by the IMF.

The idea behind the FEER approach is to model trade flows as a function of the real exchange rate and activity levels. In the medium term activity levels will be determined from the supply side i.e. the output gap will tend to zero. So if we think we know about this supply side, and we know what the current account will be in the medium term, we can back out the medium term real exchange rate. We can then form a view about the extent to which current exchange rates are misaligned (or, more precisely, what expected interest rate differentials would have to be to justify current exchange rates). I’ve used this approach on a number of occasions in the past: perhaps most notably, to try and assess what Euro/Sterling exchange rate the UK should have entered the EuroZone at if it had decided to join in 2003.

The main problem with this approach is working out what the medium term current account should be. Actual current accounts are a poor guide, because they are influenced by both noise and short term factors, like the economic cycle and currency misalignment. In long term equilibrium it is reasonable to assume that the current account should be zero, because the current account is the change in national wealth. However we know that current accounts can show persistent surpluses or deficits over many years. Intertemporal consumption theory gives us some ideas, but on its own it is not that helpful. Many other factors may matter, such as countries having different demographic profiles.  With no clear encompassing theory to use, empirical studies of the kind cited above may be our best guide.

Incidentally, the New Open Economy Macro (NOEM) approach, which is currently the most widely used microfounded open economy framework, essentially uses the same idea as the FEER: see for example this study by Obstfeld and Rogoff. It is more concerned with microfoundations, and less with data, but it shares with the FEER approach a focus on imperfectly competitive markets for internationally traded goods. As far as I know these authors have never acknowledged Williamson as a precursor, and I’m not sure why. As a result, many macroeconomists think NOEM invented this way of thinking about medium term exchange rates.

The details of which variables the authors of the ECB study find are important in determining medium term current accounts are probably not of wide enough interest to discuss in this post. What is more topical is that they use their robust models to estimate what underlying current accounts currently are for the US, UK, Japan and China. Perhaps unsurprisingly they find that, although the US would be in deficit and China in surplus, the numbers are much smaller than the deficits and surpluses observed in the recent past. More controversial, perhaps, is that they find Japan should also be running a deficit. In the past I and others have tended to assume surpluses for Japan, but this was always partly based on demographic features which were coming to an end, which is maybe what has now happened.

One slightly disappointing aspect of the study is that they did not look at Germany. There is some debate about the extent to which German surpluses represent a temporary misalignment of real exchange rates within the Eurozone, or whether they may be partly structural. The answer is rather important in assessing the extent to which deflation is required outside Germany, and it would have been very interesting to know what this study had to say on this issue.                   

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[1] I should add that I take no credit for the title - I think it came from Rebecca.