Properties of the fundamental equilibrium exchange rate in the Treasury model

Abstract

This article calculates the equilibrium real exchange rate for the UK economy. The long-run trade and supply side relationships from HM Treasury's model are used to estimate the level of the real exchange rate consistent with the UK economy growing at its 'natural' rate while achieving a sustainable current account position. The model shows that the real exchange rate associated with macroeconomic equilibrium lies well below the actual rate for most of the 1990s. This result has important implications for possible UK participation in the single European currency as, once the nominal exchange rate is fixed, overvaluation can only be corrected by holding UK inflation lower than that elsewhere. Achieving this may be costly in terms of jobs and output.

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