Determinants of the Effective Real Exchange Rate of the Synthetic Euro: Alternative Methodological Approaches

On the basis of historical data aggregated over the period 1973 to 2000, we have experimented with four different approaches to estimate the synthetic euro's equilibrium exchange rate. Using a number of competing models with the same data set, variable definitions and sample period offers the possibility to assess the uncertainty surrounding such equilibrium levels, both from an empirical (different estimates) and a theoretical viewpoint (different specifications). In this exercise, the 'Rest of the World' is proxied by the US, the UK, Japan and Switzerland, aggregated on the basis of trade weights.
We employed reduced form co–integration models, a structural VAR, a NATREX model (estimated in structural form) and the ECB's small–sized euro area wide macro–econometric model. In this order the approaches feature an increasing degree of 'structure', in the sense of the constraints based on economic theory embedded in the econometric models that were estimated. The results confirm the high likelihood for the euro having been undervalued in Q4 2000, while stressing the significant empirical and theoretical uncertainty with respect to the equilibrium exchange rate level.