RDP 2003-03: Australia's Medium-Run Exchange Rate: A Macroeconomic Balance Approach 1. Introduction

Economists have suggested a large number of – sometimes competing – theories of equilibrium exchange rate determination, partly reflecting the mixed empirical support most of these theories have. Success in explaining the behaviour of exchange rates depends importantly on the time horizon.[1] Over the short term – up to a year or so – Meese and Rogoff (1983) have shown that a random walk explains exchange rate behaviour at least as well as fundamental-based equilibrium concepts do. Fundamental-based concepts, such as purchasing power parity, have more favourable evidence over the long run. Similarly, the macroeconomic balance approach, which is based on the relationship between the current account and the exchange rate, is an explicitly medium-run concept. This paper uses the macroeconomic balance approach and applies the concept to Australian data.[2]

The macroeconomic balance approach, which is based on the simultaneous achievement of internal and external equilibrium, goes back to Meade (1951) and Swan (1963). Internal balance is reached when economies are operating at their supply potential, while external balance is defined as an ‘appropriate’ or target capital account position. The equilibrium exchange rate is defined as the level of the exchange rate that is consistent with medium-term macroeconomic equilibrium.

Using this approach, a medium-term equilibrium exchange rate can be estimated for any current account balance. This equilibrium is therefore a flow equilibrium. A sustainable current account balance, however, is not necessarily a stock equilibrium: such an equilibrium, which could be reached over the long run, implies a stable net-foreign asset to GDP ratio. This also implies that the medium-run equilibrium exchange rate consistent with a flow equilibrium can change over time, and often does so.

At any point in time, actual values of the exchange rate will reflect influences of equilibria over all three horizons. Short-run movements can reflect changes in ‘market equilibrium rates’, that is, the exchange rate that balances demand and supply in the foreign exchange market. Medium-run and long-run changes might reflect convergence to flow equilibria and stock-flow equilibria. We would therefore not necessarily expect that the actual exchange rate is at the medium- or long-run equilibrium level at any specific date. While we would expect convergence forces to bring the exchange rate to equilibrium over time, the macroeconomic balance approach is silent about the adjustment forces that might bring us there.

Section 2 explains the macroeconomic balance approach in more detail. An equation for the underlying current account for Australia is estimated in Section 3. Section 3.3 illustrates the macroeconomic balance exchange rate based on this estimate, with a sensitivity analysis in Section 3.4. Section 4 concludes.


For a summary, see e.g., MacDonald (2000) and Driver and Westaway (2001). [1]

A number of studies have related Australia's long-run exchange rate to the current account, the terms of trade and capital flows, which are variables included in the macroeconomic balance approach (see e.g., Blundell-Wignall, Fahrer and Heath (1993)). The macroeconomic balance approach was used by Isard and Faruqee (1998) and Isard et al (2001) in their Internal-External-Balance models in a multilateral framework. They focus on developing a target capital account model based on optimal savings and investment decisions. [2]