Assessing Long-Run Fair Value (PPP, FEER, BEER)

Introduction

Standing in a friend’s bustling coffee shop in Barcelona—or was it Milan?—I remember thinking, “Wait, why is espresso cheaper here than back home?” That casual thought opened my eyes to why we often talk about how currency values influence the cost of goods across countries. Economists have built frameworks to figure out what exchange rate would make prices “just right,” and that’s exactly what we explore here. We’ll dig into three classic methods for gauging a currency’s long-run “fair value”: Purchasing Power Parity (PPP), the Fundamental Equilibrium Exchange Rate (FEER), and the Behavioral Equilibrium Exchange Rate (BEER). While their names might sound fancy, they’re all attempts to answer a common question: “Does this currency look overvalued, undervalued, or about right?”

In practice, exchange rates can be all over the place in the short run—people speculate, governments intervene, markets panic, you name it. But over the longer haul, these three frameworks help folks like us see through the noise.

Purchasing Power Parity (PPP)

Purchasing Power Parity is probably the best-known concept for thinking about long-run fair value. At its core, it states that in an ideal world without transaction costs or trade barriers, the same basket of goods should cost the same across different countries once we adjust for the exchange rate. If you’ve come across The Economist’s “Big Mac Index,” you already get the gist.

Absolute vs. Relative PPP

• Absolute PPP says that if a pair of shoes costs US$100 at home, then—after accounting for the exchange rate—the same pair should cost $100 in another country’s currency. Honestly, this is a bit simplistic because shipping costs, tariffs, and local margins (plus a sprinkling of intangible cultural factors) can skew prices.

• Relative PPP is more about rates of change: The expected change in an exchange rate over time is roughly equal to the difference in inflation rates between two countries. Formally:

(Percentage change in Spot FX) ≈ (Domestic inflation) − (Foreign inflation)

So, if the domestic inflation rate is 5% and the foreign inflation rate is 2%, we’d expect the domestic currency to depreciate by about 3% over the long run to keep prices in line. You won’t see a perfect match each year, but over a multi-year horizon, relative PPP does a decent job of explaining average exchange rate movements.

Why PPP Deviates in Reality

• Non-Tradeables: Services (like haircuts or medical care) are not easily tradable across borders.
• Trade Barriers: Tariffs, quotas, or outright bans add friction.
• Consumer Preferences: Even seemingly identical items (like coffee) can be priced differently due to intangible brand effects, local wages, and taxes.
• Differences in Product Quality: The “same” product might differ in quality across countries (think local customizations or packaging nuances).

Despite these quirks, PPP offers a straightforward, intuitive lens: if inflation gets out of control in one country, that currency is likely to weaken in the long run.

Fundamental Equilibrium Exchange Rate (FEER)

If you’re more of a macro buff, FEER might be your cup of tea. Whereas PPP primarily examines goods prices, FEER focuses on macroeconomic fundamentals. It tries to identify the exchange rate that ensures “internal and external balance” over the medium term.

Under the Hood of FEER

• Internal Balance: The economy operates at full employment with stable inflation.
• External Balance: The current account position is sustainable; in other words, you’re not running massive external deficits or surpluses that call for abrupt adjustments.

FEER basically says, “At what exchange rate would the economy neither boom nor bust, and where the country’s net savings and investment flows are in harmony?”

To find this so-called fundamental rate, analysts look at a variety of structural variables:
• Productivity growth trends.
• Desired national saving vs. investment.
• Global capital flows and trading partner fundamentals.

FEER is often used in policy discussions: central banks or governments might say, “We think the FEER is around 1.10 for our currency pair,” implying that a current market rate of 1.30 is out of whack with underlying fundamentals.

Strengths and Limitations of FEER

• Strength: More robust than PPP alone. FEER accounts for capital flows, productivity, and macro balancing.
• Limitation: Complex to estimate. The “correct” measure of internal and external balance can be subjective.
• Real-World Deviation: Even if the model suggests a fair value, markets can push way off target—for years.

Behavioral Equilibrium Exchange Rate (BEER)

Behavioral Equilibrium Exchange Rate (BEER) is like a cousin to FEER but calls on big empirical models. Instead of just talking about an ideal macro balance, it hunts for real-world relationships:

• Terms of Trade: Commodity exporters, are you listening? If your export prices go up, your currency might appreciate.
• Real Interest Rate Differentials: Higher real (inflation-adjusted) interest rates can attract capital inflows, boosting the currency.
• Productivity Indicators: Countries with faster productivity growth can see stronger currencies.
• Other Variables: Sometimes it’s net foreign assets, sometimes it’s a measure of risk appetite or dummy variables for crises—basically, whatever the researcher thinks might affect currency values.

Steps in a Typical BEER Analysis

1. Collect relevant macro data (interest rate differentials, commodity price indices, etc.).
2. Regress the real exchange rate on selected variables.
3. Determine which relationships are statistically significant.
4. Estimate an “equilibrium” path for the currency based on those macro fundamentals.

BEER is widely used by investment banks and economists who want a more flexible approach than a purely theoretical one. You do have to watch out for data-mining: if you throw in enough variables, something is bound to “stick,” but it might not be reliable over time.

Comparing PPP, FEER, and BEER

Diagram of Conceptual Flow

    flowchart LR
	    A["PPP <br/>Focus on Price Levels"] --> B["Long-Run Exchange Rate <br/> Equilibrium Based on Price/Inflation"]
	    D["FEER <br/>Macro Fundamentals"] --> B
	    E["BEER <br/>Empirical Model Approach"] --> B

In the diagram, each of PPP, FEER, and BEER eventually points to an assessment of the currency’s long-run equilibrium. They simply get there via different roads, using different sets of assumptions and data.

Why Currencies Deviate from Equilibrium

Over lunch with a fellow analyst, you might joke that currencies have a mind of their own in the short run. Indeed, all three frameworks are about the “long run,” but in reality:

• Speculative Flows: Large capital movements can drive big swings that ignore fundamentals.
• Government Intervention: Pegging, managed floats, capital controls—all can keep currencies off “fair” levels for extended periods.
• Cyclical or Sentiment Factors: Risk-on or risk-off moods can overshadow fundamental valuations for a while.

Practical Item-Set Style Example

Imagine you’re handed a short vignette in the exam:

“Country A has seen inflation accelerate to 8% while Country B’s inflation is stable at 2%. Over the same period, Country A’s central bank kept nominal policy interest rates unchanged, leaving real rates substantially lower than in Country B. Meanwhile, Country A’s terms of trade deteriorated because it exports mainly oil, whose world price has slumped. However, Country A also has had robust productivity growth due to structural reforms. Current market exchange rate: 1.60 (A’s currency per B’s currency). A PPP-based assessment suggests the rate should be 1.75. A BEER model that includes real interest rate differentials, productivity, and terms of trade suggests a fair value of 1.65, whereas a local think tank’s FEER-based estimate comes out at 1.55.”

You might see questions like:

• Based on relative PPP, is A’s currency overvalued or undervalued at 1.60?
• Does the BEER model’s slightly higher rate reflect the negative terms of trade or the productivity gains, or both?
• Why might the FEER-based estimate differ even more?
• Which intangible factors (government capital controls, market sentiment) could explain why the actual rate is still at 1.60?

This kind of set-up forces you to interpret multiple angles: PPP focusing on price-level changes, FEER focusing on internal/external balance, and BEER capturing a blend of macro variables. Each method might yield a different perspective, and your job is to piece together a coherent conclusion.

Best Practices and Common Pitfalls

• Best Practice #1: Cross-Check. If PPP says one thing, but your BEER analysis is far off, you might want to re-check data or think about capital flows or structural changes.
• Best Practice #2: Understand Time Horizons. PPP is fairly long-run. If you’re trying to forecast next quarter’s move, a short-run measure like a near-term BEER or a micro flow-based model might help more.
• Common Pitfall: Over-Reliance on a Single Model. Markets are dynamic. Relying on just PPP or just FEER might give you tunnel vision.
• Pitfall #2: Ignoring Behavioral Factors. Sometimes “herding” or “momentum trading” can push a currency far from any fundamental value. Keep that in mind.

Conclusion

Judging a currency’s long-run fair value is part art, part science—like trying to find the “true” cost of a cappuccino between countries when wages, tastes, and taxes all differ. PPP gives you a neat “goods-based” anchor, FEER offers a thoughtful macro framework, and BEER leverages empirical data. In practice, these models each have their champion scenarios. You’ll often see them used together, especially in equity research, macroeconomic policy discussions, and big investment decisions.

For exam success, be sure you understand the differences among these three approaches, how to interpret their numbers, and reasons why real-world exchange rates often depart from “fair.” The item-set questions will likely test your ability to evaluate and compare these methods in a scenario-based context—and to remain calm when the figures don’t line up perfectly.

Remember: if the exam leads you to a currency misalignment, always ask yourself, “What’s driving this divergence from the model?” Then weigh the effect of short-term vs. long-term forces. And maybe think of that coffee moment in Barcelona (or was it Milan?)—sometimes it’s all about perspective.

References and Further Reading

• IMF Working Papers on “Exchange Rate Assessments: FEER, BEER, and PPP”
• “Purchasing Power Parity and Real Exchange Rates” in the Journal of International Economics
• Practitioner guides on applying BEER models for currency forecasting
• CFA Institute Level II Curriculum (2025) – Economics Sections on Parity Conditions and Exchange Rate Determination

Test Your Knowledge: Long-Run Fair Value of Currencies