Why the euro will be strong: An approach based on the equilibrium exchange rates

The real equilibrium exchange rate proposed in this paper is the long run parity which is consistent with the Balassa effect and the sustainability of the external position. Non-price competitiveness factors are also taken into account. Tests are made for three European currencies : mark, franc and lira against dollar. Observed data of real exchange rates are shown to be cointegrated with the fundamentals of the model. The three European currencies are then aggregated according to their weight in the ECU, in order to construct a proxy of the euro. An equilibrium exchange rate of the euro against dollar is calculated and the contributions of the different fundamentals are analysed.