Another well-known model-based approach, which is the one we adopt, is known as the behavioral equilibrium exchange rate.<sup>8</sup> This methodology, proposed by MacDonald (1997), is based on reduced form estimation of a long-run equilibrium relationship between the real exchange rate and a set of fundamentals, using Johansen’s (1995) cointegration techniques. The current value of fundamentals can be used to determine equilibrium exchange rates, and the difference with the actual exchange rate defines the magnitude of the misalignment.

The major advantage of these equilibrium exchange rate models, over the simple PPP framework, is that they relax the assumption of the equilibrium being static and allow for it to vary according to changes in fundamentals. However, they also have their caveats. For example, the FEER approach removes speculative capital flows from the medium-term capital account, making it difficult to account for short-term changes in the UIP condition that affect the dynamic adjustment path of the exchange rate. Moreover, the FEER approach is critically sensitive to trade elasticity estimates. Unlike the FEER, the BEER considers how changes in fundamentals affecting the capital account may impact the “behavior” of the exchange rate. This is critical for “countries that are experiencing substantial variation in short-term fundamentals (for relatively stable economies operating in the neighborhood of internal and external balance, the BEER would converge to the FEER)” (IMF 2007). However, the BEER approach relies on appropriate historical data availability, and is therefore difficult to implement in countries that have undergone substantial structural change or for which longer-term data are scarce. Sustained misalignment may also lead to misinforming results.<sup>9</sup> Another drawback is that very little economic theory guides the choice of economic fundamentals considered in the econometric analysis.

<u>Table 1: Equilibrium Exchange Rate: Alternative Concepts</u>

||**Definition of equilibrium exchange rate**|
|---|---|
|**Estimation-based appr**|**oach**|
|Black market exchange<br>rate premium|Black market exchange rate.|
|Law of One Price<br>(LOP)|Rate that equalizes prices of goods across countries, when converted in<br>the same currency.|
|Purchasing Power<br>Parity (PPP)|Rate that equalizes the real exchange rate to its level in a base year.|
|**Model-based approac**|**h**|
|Behavioral Equilibrium<br>Exchange Rate (BEER)<br>- Clark and MacDonald<br>(1997,1999)|<br>The BEER is based on reduced-form estimation of a long-run relationship<br>between the real exchange rate and economic fundamentals. Actual or<br>medium-term fundamental values are then used to obtain predicted values<br>of the real exchange rate,and an HP filter is applied,to obtain the BEER.|
|Fundamental<br>Equilibrium Exchange<br>Rate (FEER) -<br>Williamson (1983, 1994)|The FEER is the exchange rate consistent with simultaneous internal (zero<br>output gap) and external (sustainable current account) balance. It requires<br>estimation of an econometric model for the trade sector (trade elasticities)<br>and selection of the (sustainable) current account norm that is either<br>estimated empirically (MB approach) or derived as the level that stabilizes<br>the net foreign asset position (ES approach).|

> 8 Égert (2003) provides a comprehensive survey of the literature.

> 9 Several papers have dealt with this by adopting a cross-country panel framework to incorporate a wider range of country experiences (for example, Maeso-Fernandez et al, 2004, MacDonald and Dias, 2007, Ricci et. Al, 2008, and Bénassy-Quéré et al., 2009).

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