Longer-Term Exchange Rate Anchors

The goal of this technical note is to give students tools for thinking about how exchange rates will move over a period of five years into the future. While forecasting exchange rates is arguably more art than science, managers, policymakers, and investors are nonetheless often required to form opinions about the future evolution of exchange rates. Specifically, this note defines the real exchange rate and purchasing power parity (PPP) and illustrates that PPP is useful in forecasting nominal exchange rate movements for advanced economies (AEs). For emerging market economies (EMEs), the note explains that PPP is less useful and instead offers a relatively new International Monetary Fund (IMF) model, which evaluates exchange rate over and undervaluation in EMEs (as well as AEs). The note is designed to be used in a firstyear MBA course, specifically in a class structured around exchangerate forecasts based on recent supplemental data (to be added by the instructor). In this case, the class would be based on a question like, “What will the exchange rate of the US dollar be against the British pound in five years and why?” Note that IMF material is advanced and may need to be presented as a useful ‘black box’ depending on the level of the student and the place in the course. In either case, this qualification could also be used in an advanced bachelor’s or master’s degree in international finance or macroeconomics.

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