The equilibrium exchange rate for the Finnish Markka

Abstract

The purpose of this paper is to analyze the behavior of the equilibrium exchange rate for the Finnish markka in the final years of this century.We construct a small but relatively self contained dynamic macro model that seeks to capture the most essential interdependencies of the Finnish economy.This model is used in calculating the equilibrium paths for nominal exchange rate and domestic activity. The simulations show that with the projected development of foreign demand, trade prices, and domestic wages, the equilibrium exchange rate remains virtually constant over the next four years, at a level very close to the current (mid-1995) exchange rate. That allows for an approximate 4.5 percent non-inflationary average rate of growth.Changes in trade prices and foreign demand only have a modest effect on the equilibrium exchange rate; due to the combination of a non-accommodative inflation constraint and rigid wages, equilibrium is restored primarily by adjusting domestic demand and hence, the growth rate of the domestic economy. The importance of wage moderation is emphasized most dramatically in a scenario in which the rate of wage increases is assumed to exceed the baseline projection by one percent a year.In this scenario, keeping inflation at the target level requires a steady appreciation of the markka and a reduction in the average growth rate to 2.8 percent.