The Dollar/Euro Exchange Rate

While the practical policies toward the exchange rate of the Fed and the ECB are very similar, there is a major philosophical difference between the American view that governments have no business to worry about capital flows and exchange rates versus the European view that these things matter and that floating is simply not defending a particular rate. Under the first view, the only issue is what determines the exchange rate. The literature has concluded that not much can be said about this in the short run, but that in the long run misaligned rates tend to return toward equilibrium (“PPP”). Under the second view, it makes sense to ask what is the “fundamental equilibrium exchange rate” (or some FEER-like concept). Most of the evidence suggests that the dollar/euro rate at the time of writing the article ($1.27) represented at most a modest overshooting.