Equilibrium Exchange Rate
Equilibrium exchange rate refers the rate where currency supply meets demand of that same currency. Since foreign exchange rate is affected by several factors, equilibrium exchange rate is also influenced by factors of demand and supply. Therefore, equilibrium is achieved when the demand of a currency is equal to supply. Consequently, this rate equals to the PPP (purchasing power parity) of the currency where all markets are efficient and goods are traded.
This means that across all countries, the price levels need to be observed. The equilibrium rate is talked about as something that is different from what the current market rate is and this often means 2 things. One is that the real equilibrium exchange rate will at some point in the future be different from the rate observed today. Two, the policy towards nominal exchange rate facilitates in some way, adjustment towards the real future exchange rate. As such, the question on whether there is any sense in calculating equilibrium exchange rate on the basis of policy brings about two sub-questions which include whether there are analyzable and predictable real exchange rate shifts and if such shifts can be facilitated by the policy on nominal exchange rate.
There are a couple of factors that affect the shift in equilibrium exchange rate as they include:
The agreement that real events have the ability to change equilibrium exchange rate is a universal one. The only source of dispute is how frequent such shocks are as well as how large. One possible shift source in equilibrium exchange rate is secular trends presence which is as a result of technological changes and product mix differences among others. Another likely source that affects equilibrium rate is commodity price shock. For G-5 countries that are exporters, such shocks don’t have a large impact as is the case with primary exporters.
This is another controversial cause for shifts in equilibrium rate especially in capital flows noted international. Take for example a country that is a temporary recipient of capital flows. This could be as a result of an investment boom which is generated by resource discoveries or technological change attributed to tax law changes or bulge in deficits. Regardless of the source, capital inflows will be spent at a domestic level and this will raise the demand for nontrade goods that are domestically produced and in some cases, it can also raise the price of a country’s goods in the world markets.
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