Fundamental Equilibrium Exchange Rate Explained

The fundamental equilibrium exchange rate is defined as that real effective exchange rate value which is compatible with the macroeconomic equilibrium. It is the real exchange rate which produces an external balance which is accurately matched with equilibrium medium-term capital flows.

The fundamental equilibrium exchange rate is sometimes referred to as another way that estimates the real effective exchange rate equilibrium. Keeping in mind the flaws and the imperfections of purchasing power parity concept, FEER shows that the value of exchange rate which is the result of current account assets or deficit which in turn is appropriate for the long-term structural inflow of the capital or economy outflow, assumes that the country does not have restrictions to trade freely and is also trying to attain internal balance.

A significant and a specified degree of judgment value are required to assess the levels of structural outflow or inflow of the capital. And if it did not assess, then it is assumed that such structural capital inflows or outflows should abide because of their occurrence in the past.

There are wide variations in the estimated values of fundamental equilibrium exchange rates. There are models developed on the concept of FEER and there is a wide use of these fundamental equilibrium exchange rate concept based models in the private sectors for some time. Although, it is said that use of such type of a exchange rate model makes high degree of emphasis on the value judgment of the analyst who is concerned, which in the first place undermines the point of using the given model.

While discussing about the FEER and the exchange rate models that makes use of some variation of the current account approach, it can be noted that some “misalignments” in both the external balance and therefore in the exchange rates can stay over a considerable periods of time. The probability factor for the presence of misalignments suggests that for a particular periods of time the importance of the external balance to the exchange rate can be more than offset by capital flows. Eventually, the production of market losses and the outflows in capital are visible because of the level that external balance reaches as a result of misalignment. Reduction of the current account deficit occurs due to the capital outflows.

The hindrance is the varying or fluctuating nature of this point that caused loss of market confidence. Thus, for considering long term exchange rate; external balance focused models should be used and considered rather than using the exchange rate models which focus on the short term like all exchange rate models.