balance is a situation in which real output is at or close to its potential or capacity level, and the inflation rate is low and nonaccelerating (full employment and price stability), while external balance is defined as a current account position that can be sustained by capital flows on terms compatible with the growth prospects of the economy without resort to restrictions on trade and payments, so that the level of international reserves is adequate and relatively stable. (Khan, Nsouli, and Wong, 2002) In this formulation, internal balance equals trend output, and external balance is equal to the value of the target capital account. Internal balance occurs when the markets for labor and nontraded goods clear and external balance represents a clearing of the tradable goods market with an increase or decrease in the stock of net foreign assets that is need to balance the capital and the current accounts. By definition, the capital account is equal to the excess of domestic savings over investment. Thus, all the prevailing macroeconomic balance approach models see exchange rate equilibrium as the level that generates an underlying current account equal to the target capital account when the domestic and foreign economies are in internal equilibrium.

However, in practice, the choice of an appropriate base year is an inevitably subjective process, especially when dealing with aggregations of countries with different structural characteristics facing diverse terms of trade shocks. There are years in which some, but not all of the requirements are fulfilled. Furthermore, the interpretation of target current accounts is a judgment call based on views on optimal savings and investment decisions and on proper calculation of price and income elasticities of trade flows. Thus, there is an inherent difficulty in finding a year in which the current account has been at a satisfactory level. After the determination of the base year, the misalignment is judged as the percentage of deviation between the real effective exchange rate in the final year of the analysis and the equilibrium base year.

For the current analysis, the year 1999 was chosen because the average inflation in both the CEMAC and UEMOA zones was close to zero, and the economic growth in almost all countries in the zone (with the conspicuous exception of Gabon) was significantly positive. The current account deficits were not significantly different from other years, and external financial flows allowed countries to finance this imbalance between savings and investment. Chart 1 shows the breakdown of the current account deficit in 1999 in the two zones by category. In the CEMAC zone, the large negative net income (due to a combination of repatriation of oil profits by companies and interest paid on public and private debt) compensated for the positive trade balance to give a current account deficit (including grants) of -8.7 percent of GDP, while in the UEMOA zone, a trade deficit, coupled with a net income deficit resulted in a <!-- Start of picture text --> CHART 1: CURRENT ACCOUNT DEFICIT<br>AND ITS COMPONENTS IN THE CFA ZONES<br>1999 (% OF GDP)<br>10<br>5<br>0<br>Current Trade Inco me Current Capital<br>-5<br>Acco unt Trans fers Acco unt<br>-10<br>-15<br>-20<br>CEM AC UEM OA<br><!-- End of picture text --> current account deficit of -6.4 percent of GDP. Overconsumption in both zones has led to persistent current account deficits, but in both zones, a combination of aid flows and capital transfers led to a strong capital account balance to offset the current account position.

# **3. CHOICE OF   PRICE INDEX**

The analysis uses the CPI (consumer price index), which is the most commonly used price index in macroeconomic work because it is easily available on a monthly basis and because 9