Five Major Problems with the Equilibrium Exchange Rate Model of Peterson Institute

The SMIM model assumes that if a country’s exports account for 10% of its GDP, then export price elasticity will be 1; if the exports of a country accounts for 100% of GDP, then export price elasticity will be 0.5. Thus, the export price elasticity of a country can be determined by the ratio of exports to GDP.

However, as mentioned above, export price elasticity is impacted by many factors, and the ratio of exports to GDP being merely one of them. There can be significant differences in export price elasticity among different countries and different products. If an empirical model is to be built, the export price elasticity of relevant products should be estimated using actual data and econometric model.

But in SMIM, export price elasticity does not take into account these factors, and there is no measurement and calculation of the export price of each country. Rather, it assumes that export price elasticity is related to the ratio of exports to GDP. Export price elasticity derived from such a simplified and stylized model will inevitable diverge greatly from reality.

3. Exchange Rate should Be an Comprehensive Indicator of a Country’s Development Level

Exchange rate is an indicator of a country’s developmental stage, development level, and competitiveness. Changes in exchange rate are closely related to such factors as economic strength, scientific and technological advances, and industrial structural adjustment. 

The market exchange rate of a country is closely related to the economic development stage of the country. As economy progresses from underdeveloped to developed, market exchange rate will deviate less from PPP. This is the natural law of exchange rate. 

The degree of deviation of China’s market exchange rate from PPP largely corresponds to China’s current economic development stage. If RMB exchange rate is excessively manipulated to such an extent that it is artificially close to PPP, China’s economic will face serious consequences.

If the exchange rate of a country stays at an artificially high level for a long time, domestic goods will not realize their values through international exchange, production capacity will not be fully utilized, and development will stagnate. At the present stage, China, as one of the engines of world economic growth, is playing an active and important role in economic recovery and world economic development. If this engine is switched off due to exchange rate appreciation, it will be a huge loss to any other country in the world. Therefore, China needs to maintain an exchange rate corresponding to its economic development stage, in order to ensure rapid growth in the next two decades and to make significant contributions to world economic development on a continued basis.  

(Research Department   Zhang Huanbo)