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| Reference Reference information: Overvaluation and Undervaluation It is quite common to hear people claim that a country's exchange rate is overvalued or undervalued. The first question one should ask when someone claims the exchange rate is overvalued is, overvalued with respect to what? There are two common reference exchange rates often considered. The person might mean the exchange rate is overvalued with respect to purchasing power parity (PPP), or it he may mean the exchange rate is overvalued relative to the rate presumed needed to balance the current account. The mere use of these terms suggests immediately that there is some "proper" value for the exchange rate. However, one should refrain from accepting this implication. As was previously discussed, PPP is unlikely to hold, even over very long periods, for a variety of very good reasons. Also as discussed previously, there is no reason to think that current account balance represents some equilibrium or goal for an economy. Thus, overvaluation or undervaluation of an exchange rate, for either reason (PPP or CA balance) should be thought of simply as something that happens. Of more interest is what it means when it happens. |
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