Modelling Equilibrium Deviations of Exchange Rates from Purchasing Power Parity

Abstract

We construct a simple model of exchange rates stemming from the methodology of behavioural equilibrium exchange rate (BEER) models on annual panel data for 34 countries with a floating exchange rate regime during the period 2000–2020. The basic building block of the model is the absolute version of purchasing power parity theory (the ratio of domestic and foreign price levels), further extended by other variables rooted in economic theory. A complementary interpretation of our approach could be a measurement of exchange rate deviations from purchasing power parity caused by variation in economic fundamentals. The results suggest that purchasing power parity is an appropriate reference point for exchange rate models. Furthermore, national currencies tend to be stronger against the euro with higher GDP per capita, interest rates, investment freedom, urbanization rate and terms of trade, and with lower inflation. The presented deviations of exchange rates from the model equilibrium are significantly lower than those implied by a naïve model based on purchasing power parity alone.