Appendix 2 

Exchange Rate Misalignment: 

 What the Models Tell Us and Methodological Considerations 

Often one sees references suggesting that an exchange rate is in disequilibrium or 

misaligned and not at the rate “it should be” or not at a rate based on market 

fundamentals. For example, financial institutions publish estimates of “fair value,” 

implying the probable direction a currency will move in the near term, as part of their 

client services or for their own foreign exchange trading purposes. As will be shown, 

these estimates often vary considerably. In extreme cases, some exchange rate models 

generate estimates that a currency is undervalued while others conclude that the currency 

is either fairly valued or even overvalued – all using the same data at the same point in 

time. 

A Multi-Faceted Issue Where Much Can Go Wrong 

Many approaches have been developed to estimate “proper” or “equilibrium” exchange 

rate values based on different views about how economies and financial markets work. 

Conclusions are then drawn as to whether a currency is misaligned based on the deviation 

of the actual observed exchange rate from the predicted proper exchange rate. Although 

it is broadly understood that no single model accurately explains exchange rate 

movements, estimated models still produce useful information. 

For example, simplified models do not adequately describe all the millions of daily 

events in a modern economy relevant to determining an equilibrium exchange rate. This 

is especially true of economies that are fully integrated into the international economic 

and financial system. It is also highly unlikely that existing empirical techniques are able 

to fully capture all the relevant structural changes that occur within and among 

economies that influence exchange rates. 

Though there is no “fail safe” method of estimating the proper value of an economy’s 

exchange rate or the extent of its misalignment, it is possible to calculate useful indicators 

and approximations. However, here too there are problems. One major problem is that 

most exchange rate models are “trade based” with the results keyed to finding the 

exchange rate that balances cross-border trade of goods and services. But exchange rates 

are prices that are determined in trading in large financial markets. Trade flows are 

dwarfed by financial market transactions – global trade in goods and services for all of 

2005 was $12 trillion while more than $15 trillion in transactions flow through foreign 

exchange markets in a single week. Persistent trade balances can, over time, shift the 

ownership of financial instruments and thus exert a long-term influence on financial 

markets. At the same time foreign demand for a country’s assets can change the savingsinvestment balance and thus current account balances. Models that fail to account for the 

underlying dynamics of financial markets, driven by portfolio and investment 

management factors, are subject to sizable error as they treat either minimally or not at all 

some of the most important determinants driving exchange rates. 
2

Adding to the confusion is the practice of using multiple definitions of exchange rates. 

For example, some models focus on the nominal bilateral exchange rate between 

currencies (e.g., the rate one U.S. dollar is exchanged for one Japanese yen). Other 

models use an index of the value of a currency in terms of many exchange rates with 

weights based on the value of a country’s global trading pattern (i.e., trade-weighted 

exchange rates) but not on the country’s global financial flows. Additionally, some 

models express currency values in “real terms” to take account of changes in relative 

domestic prices and thus capture the global purchasing power of a currency. Those 

accounting for changes in relative goods prices are known as real effective exchange 

rates (REERs) and are the exchange rates most commonly associated with trade based 

models. 

Lastly, there is the practical consideration of the ability of each country to choose its own 

exchange rate regime. Each of the 184 members of the International Monetary Fund has 

an exchange rate regime that falls within one of eight different categories. Roughly half 

(79 countries) have adopted either floating or managed floating exchange rates (they 

account for 64 percent of global output). The remaining countries have adopted either 

conventional or crawling pegs, or currency boards or have no separate currency. The 

process of adjustment to equilibrium differs sharply depending on the choice of exchange 

rate regime. 

What do the Models Say? 

Rendering a view on misalignment depends first on establishing some notion about the 

definition and conditions constituting the equilibrium value of the exchange rate. Not all 

models are the same in this respect, and many approaches are in use. 

The oldest, and perhaps best known, is that of “purchasing power parity”. The Big Mac 

index published by The Economist magazine employs a narrow, but interesting, version 

of this approach, focusing on the price of one good and bilateral exchange rates. Models 

typically focus, however, on the REER because the real rate is often regarded as a 

measure of international competitiveness. Some analysts simply compare the current 

value of a REER with its historical values. Others incorporate a “macroeconomic” 

approach that takes into account saving-investment positions and sustainable current 

account balances. Still others focus on fundamental characteristics of an economy, such 

as changes in productivity of traded and nontraded goods sectors and relative openness. 

Many models concentrate on finding an exchange rate that will yield external and internal 

balance in the medium term, with inadequate consideration given to the possibility that 

this balance may not be consistent with efficient economic performance or with 

equilibrium in financial markets. 

The many estimates available indicate that different approaches can produce widely 

different results. One financial institution develops several measures of misalignment of 

emerging market currencies, using different equilibrium concepts. A Treasury staff 
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study1

 notes that the estimates for the real effective value of the Venezuelan bolivar in 

September 2005 varied from an undervaluation of 18 percent to an overvaluation of 87 

percent. Estimates of undervaluation of the Mexican peso ranged from seven to 40 

percent. A cross-section of estimates by different financial institutions produced results 

on the Argentine peso ranging from a 15.5 percent overvaluation to an 18 percent 

undervaluation and on the South Korean won ranging from an eight percent 

overvaluation to a 24 percent undervaluation. 

The models also tell us that they are extremely sensitive to the selection of the deflator 

used to generate a real value index. For example, drawing on IMF data the U.S. dollar in 

2004 was found to be either 17 percent below its 1980-99 real effective average, just 

below, or just above depending on the deflator used. The Canadian dollar was found to 

be above its average when deflated by unit labor costs but below its average when 

deflated by consumer prices. The exact opposite results were found for the Japanese yen; 

above when deflated by consumer prices but below when deflated by unit labor costs. 

Evaluating Misalignment 

Still, model-based assessments are typically grounded in empirical estimation and can be 

useful tools provided they are interpreted with a full understanding of the properties and 

sensitivities that underlie their computations. With full recognition that financial market 

flows are rarely, if ever adequately incorporated into the models, and that the models 

must be selective in the variables they choose to use, what is the best manner to proceed? 

One approach might be as follows: 

• Focus only on serious misalignments. Use of small deviations run too great a risk 

of “false positives” as was shown above when different price deflators were used. 

• Focus on real effective, not bilateral exchange rates. Only real effective exchange 

rates capture the multilateral, multicurrency world that exists in reality. They are 

typically the only rates consistent with trade-based models. 

• Use as many models as possible; there is no broadly accepted “right” model. If 

many models point in the same direction with roughly similar results, then the 

likelihood of obtaining an accurate judgment is much improved. 

• Recognize that no model will provide a precise answer. Point estimates are often 

published, but it is best to know the confidence interval for the estimate. 

Empirical work requires working with data subject to error, and error terms and 

confidence intervals can be high. For instance one scholar noted his estimates 

needed to be given +/- 15 percent confidence interval. This imprecision casts 

doubt on any precise measure of misalignment, boosts the probability of finding a 

false positive, and encourages concentrating on substantial misalignments. 

 

1

 Forthcoming Treasury Occasional Paper, Equilibrium Exchange Rate Models and Misalignment, by T. 

Ashby McCown, Patricia Pollard, and John Weeks. 
4

• Focus only on ‘protracted’ misalignments where currency adjustments are not 

taking place. The models used to estimate equilibrium exchange rates do not 

typically describe formally exchange rate adjustment mechanisms. It can be 

necessary to repeat estimates over time to establish whether a currency that is 

potentially misaligned is adjusting or not. Even then there is scope for error. 

Structural changes occur continually in a multi-country world and so too do 

changes in equilibrium exchange rates. 

• Even then, judgments about misalignment must be supplemented by analysis of 

empirical data, indicators, policies and institutional factors. Such supplemental 

factors might include persistent one-way intervention in exchange markets, 

controls on capital movements, lack of currency flexibility, and dependency on 

exports. 

• Lastly, one should verify whether there are any market-based reasons for a 

currency’s misalignment. For example, a model may not account for the risk of 

investing in a particular currency. Higher risk weakens international demand, 

even if productivity is rising. Or, the deviation might reflect defective institutions 

that weaken the adjustment process and dampen currency demand. Similarly, 

high interest rate differentials, when there are little apparent offsetting currency 

movements, can impact capital flows. 

Provided the process is well disciplined, relies on established principles, and, 

critically, is supplemented with additional analysis, the weaknesses of certain 

approaches to the assessment of misalignment can be largely overcome. Moreover, 

models can reasonably be expected to improve with time. Although no isolated 

approach will be fail safe, the existence of protracted misalignment, with little 

modification of the factors sustaining the misalignment, can be a significant 

impediment to the efficiency of international adjustment mechanisms and the smooth 

operation of the global economy and ought to be analyzed.