A synthetic indicator for the currencies of the G5 countries

Abstract

This paper proposes a synthetic divergence indicator retracing the influence of domestic and external imbalances for each G5 country on its currency position. This index happens to be equal to the weighted sum of domestic demand pressures and current account disequilibrium, with the weights stemming from a suitable combination of price and income elasticities estimated from a set of international trade equations. Under some restrictive assumptions, it is shown that the variations of this indicator are tantamount to the deviations of the real effective exchange rate from its long term equilibrium path. In order to determine the divergence indicator for the period 1974/1987, an empirical attempt has been carried out that resorts to a matrix of international trade encompassing the nine main industrial countries and retains a real effective exchange rate concept endowed with aggregative properties that replicates closely the effective exchange rates of the IMF MERM model at least for the major currencies. A perusal of the empirical results for the years 1985/1987 suggests that the G5 European currencies are presently close to their equilibrium position, whereas the overvaluation of the US dollar and undervaluation of the yen are still substantial