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The study found that all four models agreed that the euro was undervalued, but the estimated magnitude of its undervaluation varied widely from model to model—from 5 percent to 27 percent. From an investor’s perspective, the failure of these models to agree on what level of the euro represents long-run equilibrium could have a major bearing on how much foreign exchange risk one would be willing to undertake. 36 DOLLAR OVERVALUATION AND THE WORLD ECONOMY 73632$$CH2 01-21-03 11:36:53 Investors who believe that the euro is only moderately undervalued might prefer to maintain a portfolio posture that is close to neutrally weighted toward the euro.

Dollar cycles often begin from a point of significant overvaluation or undervaluation on a PPP basis. 11 US dollar purchasing power parity (Deutsche Bank PPP estimates based on 1982-2000 averages) Note: The zero line represents the long-run equilibrium level of PPP. Source: Datastream, Deutsche Bank estimates. to correct the initial misalignment. But market forces seldom stop driving the dollar lower or higher once PPP has been restored. Rather, the dollar often enters a second phase in which the marketplace drives the dollar well beyond its estimated PPP value, and in the process creates a new and rather large PPP misalignment with the opposite sign of the dollar’s initial misalignment.

Samuelson, Paul A. 1964. Theoretical Notes on Trade Problems. Review of Economics and Statistics 46 (March): 145-54. Wren-Lewis, Simon, and Rebecca L. Driver. 1998. Real Exchange Rates for the Year 2000. POLICY ANALYSES IN INTERNATIONAL ECONOMICS 54. Washington: Institute for International Economics. 34 DOLLAR OVERVALUATION AND THE WORLD ECONOMY 73632$$CH1 01-29-03 11:25:37 2 The Dollar’s Equilibrium Exchange Rate: A Market View MICHAEL R. ROSENBERG In theory, a currency’s value should gravitate over time toward its real long-run equilibrium value.

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