Literature review

3.1 equilibrium exchange rate theoretical research review

The equilibrium exchange rate (EER) is commonly defined in three ways .The first definition comes from the most common equilibrium concept in economics. When supply of foreign exchange equals the demand, the level of exchange rate is equilibrium exchange rate. The second definition of EER is the exchange rate which can be calculated by using some specific exchange rate determination models. The last definition refers to the exchange rate which is “consistent with the simultaneous achievement of internal and external balance”(Williamson,1985).In this paper, the second method will be adopted ,that is to say, the equilibrium exchange rate will be estimated by a theoretical model.

Different levels of equilibrium exchange rate can be obtained based on different theoretical models corresponding to specific theoretical assumptions. Currently, the most influential theories of estimating EER are mainly Purchasing power Parity (PPP) approach, the Macroeconomic Balance (MB) approach, Fundamental Equilibrium Exchange Rate (FEER) approach, Natural Real Exchange Rate (NATREX) approach, and Equilibrium Real Exchange Rate (ERER) approach, Behaviour Equilibrium Exchange Rate (BEER) approach. All models mentioned here will be discussed in the following pages.

3.1.1 the purchasing power parity (PPP) theory

The purchasing power parity theory popularized by Gustav Cassel (1992) is considered as a milestone theory of accessing equilibrium exchange rate. The theory is supported by “law of one price”, which states that “in absence of the cost of transaction and transportation, identical goods in any country must be sold at the same common currency price” (Copeland, 1997). According to PPP theory, the equilibrium exchange rate between any two countries can be determined by the relative purchasing power of their currencies, namely, their own price levels. We identify this theory as absolute PPP which will be improved by the relative PPP theory later. And the following equation 1 gives mathematical description of absolute PPP.

(1)

Where: E stands for nominal exchange rate expressed as units of domestic currency per unit of foreign currency. P and P* is the price index of domestic country and foreign country respectively. The types of commodity and the weight of each type should be absolutely the same when we calculate P and P*. However, there are great differences between any two countries in the level of national economic development, economic structure and consumption structure. Therefore, it is very difficult to measure P and P* in practice. What’s worse, the assumption of “law of one price” may not exist in real world. Because of these problems, the relative purchasing power parity is announced by researchers afterwards. The basic idea of relative PPP is that changes in exchange rate between the two countries in proportion to changes in price levels with the same period. It can be expressed in the following equation:

= (2)

Where: Et and E0 stand for nominal exchange rate expressed as units of domestic currency per unit of foreign currency in period t and base period. Pt and P0 donate the price index of domestic country in period t and base period respectively. And then, P*t and P*0 represent the price index of foreign country in period t and base period. According to relative PPP theory, the base period need to be determined at the beginning, which is judged in the macro-balance. The real exchange rate in base period is considered as equilibrium exchange rate. The nominal exchange rate in period t can be calculated by the equation 2. And then, the real exchange rate can be obtained after adjusting the nominal exchange rate. If there is a difference between the real exchange rate in period t and the real exchange rate in base period, which means that the exchange rate begins to deviate from the equilibrium exchange rate. Not difficult to find, the traditional purchasing power parity theory indicates that the real exchange rate has to remain unchanged to the equilibrium level. But the fact in real economic life tells us that the real exchange rate changes frequently in every country. A lot of empirical studies about exchange rate movements after the collapse of Bretton Woods system have shown that the purchasing power parity theory is not applicable to the majority of currencies in the world. However, the PPP theory has been valued by academics with the development of econometric technology and a large increase in sample data. Scholars have been using the new measurement methods to re-test its applicability which break the limit of traditional ways. Chou and Shih (1998) accessed the movements of equilibrium exchange rate of RMB based on PPP theory. They find that RMB is overvalued in 80’s and early 90’s , while most of the foreign researchers insisted that the yuan grossly underestimated (Overholt, 2003; Frankel, 2004; Goldstein, 2004). On the contrary, Chinese scholars are more inclined to believe that RMB is not undervalued or have not been seriously underestimated (Yu qiao, 2000; Tang guoxin & Xu jiangang, 2003; Dou xiangsheng & Yang xin, 2004). The reason why these conclusions differ greatly is that the selected exchange rate indicators and base period are different. The PPP theory did not take the effect of changes in economic fundamentals into account, so the results generally overestimate the degree of exchange rate misalignment. However, economic fundamentals change dramatically in developing and transition economies, for instance, the situations in china. Obviously, there would be a serious deviation of the conclusions drawn by ignoring the changes in equilibrium exchange rate due to changes in basic economic factors. What’s more, the theory itself does not contain the macroeconomic implications of internal and external balance (Driver and Westaway, 2004; Rogoff, 1996). Therefore, it is unreasonable to measure RMB’s equilibrium exchange rate by PPP model.

3.1.2 the Macroeconomic Balance theory

All theories mentioned above, except PPP approach, can be called “non-PPP” approach. From here, researchers begin to pay attention to the macroeconomic balance rather than just the changes in relatively price index. The expert in International Monetary Fund (IMF) Swan (1963) put forth the earliest MB theory based on the research of Nurkse (1945). The equilibrium exchange rate defined by Swan is the real rate which is consistent with internal and external balance. Furthermore, the internal equilibrium is defined as full employment and external equilibrium is balance of international payments. The author not only gave the conditions to achieve the equilibrium exchange rate, but also supplied the method to judge the characteristics and reasons of internal and external imbalances. The research of Swan made great contributions in the following areas. First of all, there is a clear distinction between internal and external balance, and the criterions