10 Determinants of Nominal Exchange Rates: A Survey of the Literature

Chorng-Huey Wong, Mohsin Khan, and Saleh Nsouli
Published Date:
April 2002
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Graciana del Castillo

Traditional models of exchange rate determination have focused on three types of explanatory variables: national price levels, interest rates, and the balance of payments. Although the perception that exchange rates are related to national price levels had existed for a long time, it was with Cassel’s introduction of the term purchasing power parity (PPP) in 1918 that exchange rates became closely associated with the comparative purchasing powers of national currencies. Policymakers were also aware that the behavior of exchange rates could be influenced by adjustments in interest rates: when interest rates rise, the exchange rate—the price of foreign currency in terms of domestic currency—falls, indicating an appreciation, or strengthening, of the domestic currency. The relationship between the interest rate and the exchange rate—known as the interest rate parity hypothesis—was bolstered as forward exchange markets developed. The recognition that exchange rates adjust to international payments established a relationship between the exchange rate and the balance of payments. With the Keynesian revolution and the rapid expansion of international capital transactions related to international trade, however, the behavioral links between the balance of payments and the exchange rate were reexamined and embedded in models that took into account the interplay of external and internal pressures on exchange rates.

The advent of flexible (or managed) exchange rates in the early 1970s, coupled with greater capital mobility, increased the volatility of exchange rates and stimulated renewed interest in their economics, leading to new developments in the theory and empirical testing of exchange rate models. The asset market approach, originally developed for fixed exchange rates, was soon adapted to the new reality of generalized floating. This approach viewed the exchange rate as moving to equilibrate the international demand for stocks of money, rather than the international demand for flows of goods, as under the more traditional approach. The asset market approach placed special emphasis on the role of expectations in exchange rate determination, and proponents explored different formulations of these expectations. In modern models of exchange rate determination, the exchange rate, being the relative price of two national monies, is determined primarily by the relative supply of and demand for these monies. In turn, demand and supply depend on expectations, incomes, rates of return, and other factors that are relevant for portfolio choices.

This chapter examines the econometric literature on models used to determine exchange rates and provides an in-depth analysis of their empirical validity. The chapter begins with a discussion of the fundamental hypotheses underlying the models—-PPP and interest rate parity—and comments on the models’ empirical validity. It then briefly reviews early models of the current account and the pricing-asset equilibrium models of the balance of payments under fixed exchange rates, which became the basis for modeling the behavior of flexible exchange rates after the collapse of the Bretton Woods system. The chapter then moves to an analysis of models of exchange rate dynamics during the transition to flexible regimes and reviews the models that have adopted the modern asset markets approach to determining exchange rates during the transition. These models have been tested under both flexible-price and sticky-price assumptions and now offer a more refined, portfolio-balance approach.

Exchange Rates and Prices

The link between exchange rates and the national price level was first articulated by scholars of the Salamanca School in sixteenth-century Spain and is often found in the writings of nineteenth-century British economists, among them David Ricardo.1 Gustav Cassel, the Swedish economist who coined the term, popularized the PPP hypothesis by making it the centerpiece of his theory of exchange rates. Although much controversy surrounds the usefulness of the PPP hypothesis, the theory does highlight important determinants of long-run exchange rate changes.

The Purchasing-Power-Parity Hypothesis

There are two versions of the PPP hypothesis. The absolute PPP hypothesis posits that, in the absence of transportation costs, barriers to trade, and any other type of control on either prices or quantities, the equilibrium exchange rate between the currencies of two countries equals the ratio of domestic to foreign prices:

where S is the nominal exchange rate measured in units of domestic currency per unit of foreign exchange, P is the domestic price level, and P* is the price level in the foreign country (* indicates a foreign variable).2 The relative PPP hypothesis states that the exchange rate should be proportional to the ratio of the national to the foreign price level:

where k is a constant parameter that accounts for (constant) transportation costs and other impediments to trade. In logarithmic form, equations (10.1) and (10.2) are expressed as follows:

where s, p, and p* are the logarithms of S, P, and P* and k = 0 under absolute PPP. Under either version of PPP, a change in the ratio of price levels will be reflected in an equiproportionate change in the exchange rate. If Π represents the rate of inflation, the dynamic version of PPP is as follows:3

indicating that countries with comparatively high inflation rates have depreciating currencies.

The PPP hypothesis is often expressed in terms of the real exchange rate (E)—that is, the relative price of foreign to domestic goods (a measure of international competitiveness):4

or, in its logarithmic form:

Note that the PPP hypothesis does not make any general assertion about the direction of causality between exchange rates and national price levels.5 PPP is in fact consistent with two-way causality, in which exchange rates adjust to changes in the ratios of national price levels, and inflation rates adjust simultaneously to changes in exchange rates, PPP in fact suggests a relationship between endogenous variables, not a complete model of exchange rate determination (Isard, 1995).

As discussed by Frenkel (1976), many of the controversies surrounding PPP pertain to the issue of which indices should be used to compute the parity. One extreme view argues that the price index should pertain to traded goods only (Angell, 1922; Bunting, 1939; Pigou, 1920; Viner, 1937), The other extreme view argues that the price index should cover the broadest range of commodities (Hawtrey, 1919; Cassel, 1928). Isard (1995) notes that most of the empirical literature focuses on the relative PPP hypothesis, since price indices are more readily available than absolute price levels. The most frequently used price indices for estimating PPP are the consumer price index (CPI), the wholesale price index (WPI), and the unit labor cost index.

In effect, the PPP hypothesis is assumed to hold under the following conditions. First, perfect substitutability among traded goods exists, and the law of one price holds for each good. The law of one price states that, in competitive markets free of transportation costs and official barriers to trade (such as tariffs), identical goods sold in different countries must sell for the same price when their prices are expressed in the same currency unit.6 Second, factor price equalization and identical production functions bring the prices of nontradable goods into equilibrium internationally. And third, each good in the aggregate price indices of the two countries has identical weights. If these conditions hold, the hypothesis predicts that an increase in the domestic price level (indicating a decline in the currency’s domestic purchasing power) will cause a proportional depreciation of the domestic currency.

Arguments Against the PPP Hypothesis

Several arguments have been made against the PPP hypothesis. One of the most frequent is that the assumptions are unrealistic. First, there is no reason that the law of one price need hold, since transport costs and barriers to trade do exist and may even prevent some goods and services from being traded. Second, consumption baskets differ across countries and thus may vary in price, even in the absence of trade restrictions. And third, monopolistic or oligopolistic practices in the market for goods may weaken the link between the prices of similar goods sold in different markets. These three factors may cause national price levels to diverge even in the long run (after all prices have had time to adjust to their market-clearing levels). Departures from PPP are likely to be larger in the short run because prices are often sticky and take time to adjust (Krugman and Obstfeld, 1988). Isard (1976) argues that perhaps the main reason to doubt the validity of the PPP hypothesis in the short run is that because of product diversification and pricing under imperfect competition, the prices (expressed in a common currency) of narrowly defined categories of manufactured goods in different countries often show large and persistent deviations from the law of one price, following changes in nominal exchange rates.

Arguments against the PPP hypothesis have been strengthened by evidence of large and prolonged fluctuations in real exchange rates over time and of economic forces that generate changes in the relative prices of tradable and nontradable goods (and thus in real exchange rates in the long run). The first argument rejects the PPP hypothesis in the short run, but it does not necessarily negate the proposition that real exchange rates fluctuate around time-invariant means or equilibrium values over the long run. The second argument points out that the long-run relevance of PPP may depend on whether the hypothesis is applied to the price level of tradable goods alone or also includes nontradable goods. Applying it to the latter may violate the assumptions mentioned earlier. In fact, ample evidence exists of cross-country differences in production functions, consumer preferences, and factor endowments, as well as in productivity growth (the so-called Balassa-Samuelson effect). Such structural differences are reflected in differences in the relative prices of tradable and nontradable goods and in price-index weights (Isard, 1995; Balassa, 1964; Samuelson, 1964).

Empirical Evidence

Graphical analysis and econometric testing on exchange rate behavior have provided strong evidence that the PPP hypothesis is not valid in the short run (Isard, 1976; Dornbusch and Krugman, 1976; Kravis and Lipsey, 1971, among others). In fact, the behavior of the real exchange rate in the short run closely resembles a random walk, without a tendency for changes in real exchange rates to reverse themselves over time.7 Evidence also exists that the variability is greater in a floating-rate regime than under fixed rates (Frenkel, 1981a; Genberg, 1978; Cumby and Obstfeld, 1984). Studies based on long-term data, however, provide evidence that real exchange rates do have a tendency to revert eventually toward their mean, albeit very slowly (MacDonald, 1997a; Froot and Rogoff, 1995).

Exchange rate variability increased considerably after the breakdown of the Bretton Woods system in the early 1970s. Two main explanations have been posited for the lower variability during the fixed exchange rate period. Mussa (1986) argues that the sluggish adjustment of national price levels can help explain the drop in variability in real exchange rates when the officials are committed to keeping nominal exchange rates fixed. Stockman (1988) argues that pressure on international reserves generated by real shocks are of greater policy concern in a fixed exchange rate system than under a float, since policymakers are more likely to attempt to dampen the effect by imposing trade restrictions, capital controls, or equivalent taxes. Historically, another factor influencing exchange rate variability is the degree of international capital mobility.

Converting equation (10.3) to examine long-run equilibrium relationships yields the following test of the PPP hypothesis:8

where β1 are the coefficients to be estimated, t is a time subscript, and μ is an error term.9 The hypothesis to be tested is β1 = 1 and β2 = –1.10

Tests of PPP using the real exchange rate have examined whether the real exchange rate follows a random walk (the null hypothesis)11—that is,

or follows the alternative hypothesis, which states that real exchange rates are reverting to the mean over time:12

where 0 < ϕ < 1.

The rejection of the null hypothesis provides evidence of long-run reversion to the mean, and consequently of PPP.13 In a recent survey of exchange rate economics in the past two decades, Taylor (1995) points out that the PPP hypothesis has variously been viewed as a theory of exchange rate determination, as a short- or long-run equilibrium condition, and as an efficient arbitrage condition in either the goods or the assets market (Officer, 1976; Frenkel, 1976 and 1978; Dornbusch, 1987).14 Taylor also explains how professional consensus on the validity of the hypothesis has shifted radically over time. Prior to the early 1970s float, there was strong support for a fairly stable real exchange rate. The prevailing orthodoxy of the 1970s, which was largely associated with the monetary approach to the exchange rate, assumed the much stronger proposition of continuous PPP (Frenkel, 1976). In the mid- to late-1970s, this extreme position was largely abandoned because of the presence of highly variable real exchange rates—a development Frenkel (1981a) refers to as the collapse of the PPP hypothesis. Subsequent studies dating largely to the 1980s further eroded confidence in the PPP hypothesis, because they were unable to reject the hypothesis of random walk behavior in real exchange rates (Adler and Lehmann, 1983; Meese and Rogoff, 1983a, 1983b). This research led to the belief that the PPP hypothesis was of little empirical use and that real exchange rate movements were highly persistent (Dornbusch, 1988). More recently, researchers have examined long-run PPP by testing for cointegration between the nominal exchange rate and relative prices. Earlier cointegration studies failed to report a significant mean reversion of the exchange rate toward PPP for the recent float experience, although they supported reversion toward PPP for the interwar float, for the U.S.-Canadian float of the 1950s, and for the exchange rates of high-inflation countries. More recent studies on long-run PPP among the major industrial countries, however, have shown more encouraging results for the managed-float period.15

Exchange Rates and Interest Rates

Policymakers have also long been aware of the link between exchange rates and interest rates and have often resorted to increasing interest rates in an effort to strengthen the domestic currency. After World War I, at a time when trading in forward exchange had greatly expanded,16 Keynes in 1923 put together the first systematic presentation of the interest rate parity hypothesis (see Keynes, 1932). This hypothesis holds that interest rate differentials are the most fundamental determinant of a market’s preferences for holding funds in one international center rather than in another, if assets are identical except in their currency denomination and interest rates.

The Interest Rate Parity Hypothesis

The interest rate parity hypothesis has two versions, both of which assume that assets are perfect substitutes and that perfect capital mobility holds. The covered interest parity (CIP) hypothesis expresses the forward premium, or discount, that must be paid at time t to hedge, or cover, the exchange rate risk associated with a contract denominated in foreign currency at time t + 1.17 Settings St and ft as the logarithms of the spot exchange rate St, and the forward exchange rate Ft,18 setting it as the nominal interest rate, and letting an asterisk (*) denote the foreign country, the CIP hypothesis can be approximated as

The uncovered interest parity (UIP) hypothesis, in contrast, is formulated in terms of expectations about future exchange rates (and is thus difficult to test given the lack of data on expectations). Letting Et st+1 denote the expected value at time t of the spot exchange rate at t + 1, the UIP can be approximated by

The joint hypothesis, referred to as the efficient market hypothesis, implies that interest rate differentials should be unbiased predictors of changes in exchange rates. In other words, the CIP and the UIP hypotheses together imply that

Given the absence of reliable data on exchange rate expectations, it is difficult to reach any conclusion about the validity of the UIP hypotheses. However, the UIP hypothesis can be combined with the notion that the expected future spot rate, even if unobservable, can be regarded as a predictor of the actual future spot rate:

where μt+1 denotes the prediction error. Thus, the change in the spot rate can be predicted by the interest rate differential,

In other words, the level of the spot rate can be predicted by the forward rate,19

Empirical Evidence

Isard (1995) discusses two contradicting sources of empirical evidence on the CIP hypothesis: interviews with market makers and studies of recorded data on exchange rates and interest rates. The interviews reveal that this hypothesis is used as a formula for determining the exchange rates and interest rates at which trading is conducted. Traders use interest rates on bank deposits denominated in different currencies to determine the forward exchange premium, or discount, they quote to bank customers. Decision makers in other parts of the bank use the spread between the forward and spot exchange rates to set the interest rates they offer on foreign-currency deposits relative to those on domestic-currency deposits.20

Studies of recorded data on exchange and interest rates, however, have often deviated from the CIP hypothesis. Earlier studies relied on data associated with claims on different countries, and deviations were rationalized in terms of political risk, capital controls, or transaction costs. Data selection in later studies has been more rigorous, not only because identical claims are used, but also because the CIP hypothesis is estimated with contemporaneous exchange rates and interest rates. Taylor (1989) tests whether it is ever profitable for a trader to conduct covered arbitrage, either from sterling to dollars or from dollars to sterling, and reaches three broad conclusions.21 First, potentially exploitable arbitrage opportunities do occasionally occur during periods of turbulence but not during calm periods. Second, market efficiency seems to increase over time, so fewer and smaller profit opportunities exist during later periods of turbulence than during earlier ones. Third, the frequency, size, and persistence of profitable arbitrage opportunities appear to be positive functions of the length of the maturity examined. With the exception of periods of market turbulence, then, the CIP hypothesis is almost always valid if financial assets are perfect substitutes and are thus subject to the same risk factors.

Evaluating either the interest rate differential as a predictor of the change in the spot exchange rate or the forward rate as a predictor of the level of the spot rate requires addressing two issues: the general magnitude of the prediction error, and any bias in the predictions. Extensive empirical evidence about the size of the prediction error shows that the interest rate differentia] explains only a small portion of subsequent changes in exchange rates (Isard, 1978; Mussa, 1979; Frenkel, 1981b). This claim has been widely interpreted as evidence that the predominant part of the observed change in exchange rates is triggered by unexpected information about economic and political events.22 Econometric tests of bias in the prediction (relating to the efficiency of the foreign exchange market) have taken the following forms (Meese, 1989):


In these equations, expectations are assumed to be rational and conditional on whatever information is available, and the forecast errors μt+1 are thus assumed to be serially uncorrected with zero means. The unbiasedness hypothesis is α1 = 1, or β1 = 1. It has received strong support from studies based on equation (10.16) but is strongly rejected by studies based on equation (10.17). Because the sample variances of the spot rate and the forward rate are essentially equal, it is now accepted that equation (10.16) is not a legitimate regression equation and, thus, that a hypothesis assuming a lack of bias can be strongly rejected (Isard, 1995).

A Possible Explanation for the Prediction Bias

Different explanations for the prediction bias have led to different views about the appropriate way to analyze the behavior of exchange rates.23 One view rejects the UIP hypothesis but not the assumption of rational expectations and provides explanations based on the risk premium. The second view does not reject the UIP hypothesis or rational expectations and provides explanations based on the so-called peso problem, simultaneity bias, and self-fulfilling rational bubbles. A third view abandons the assumption that all market participants are fully rational.24

The first explanation for prediction bias (attributing the bias to the existence of a risk premium and rejecting the UIP hypothesis) has led to the portfolio balance approach to exchange rates and models of the risk premium (ξ), which is generally defined as the deviation from the UIP:


The second explanation links the prediction bias to the peso problem. Before the widely anticipated 1976 devaluation in Mexico, the Mexican peso sold at a forward discount for a long time. The fact that the devaluation did not take place immediately after economic agents first anticipated it made the forward rate a biased predictor over the period in which the devaluation failed to materialize, even though market expectations eventually proved correct and may well have been rational ex ante (Lizondo, 1983; Rogoff, 1980; and Krasker, 1980).25

Exchange Rates and the Balance of Payments

The link between exchange rates and the balance of payments is not new. Isard (1995) traces its origin to the fourteenth century, when secondary markets for bills of exchange issued by different European banking centers were established. He argues that the link was strengthened during the seventeenth century with the problems created by the outflow of specie from British and Italian markets. It was transformed in the middle of this century with the Keynesian revolution and the rapid expansion of capital transactions concurrent with international trade. Thus, the analysis of the exchange rate adjustment process became firmly embedded in models that focus on the simultaneous pursuit of external and internal balance.

Early Models of the Current Account

The Great Depression of the 1930s sharply contracted output and employment, and countries reacted by imposing trade barriers that significantly affected international trade. A new explanation for balance of payments adjustment soon followed. Although the new approach was an outgrowth of Keynes’s General Theory, it was attributed to Robinson’s (1937) classic article in the late 1930s and perhaps first developed by Bickerdike (1920).26

According to Isard (1995), the challenge of macroeconomic modeling during the 1940s and 1950s was to open up the Keynesian model. This challenge had to be met in the framework of an international monetary system with exchange rates that were pegged and infrequently adjusted and capital flows that were growing but still small in relation to the flow of merchandise trade. In this environment, most models of exchange rates and the balance of payments treated the current account—and usually just the trade balance—as the only endogenous component of trade. At the same time, the exchange rate was assumed to be exogenously given, or a choice parameter to be fixed by the authorities. Thus, not much attention was paid to the role of expectations in modeling the behavior of economic variables. Despite these limitations, the early current account models contain some of the main features of modern forward-looking models of flexible exchange rates. In these early models, expectations about the future path of the exchange rate are constrained to be consistent with a sustainable path for the current account (Hooper and Morton, 1982).

The earliest and perhaps best-known models of balance of payments and exchange rate determination follow the elasticity approach. This approach is based on the Marshallian tradition of treating the exchange rate as a relative price that clears a market with well-defined flow demand and supply curves. Later versions try to incorporate the analysis of national income accounts in the Keynesian tradition. These models emphasize that a change in the exchange rate affects the current account balance only if it induces a change in domestic absorption relative to domestic production (Bickerdike, 1920; Marshall, 1923; Robinson, 1937; Lerner, 1944; and Metzler, 1949).

The standard model analyzes the effect of exchange rate changes on the current account in terms of separate markets for home-produced and foreign tradable goods, typically abstracting from the existence of any nontradable goods. The stylized model (Dornbusch, 1975) assumes that export supplies (X) and import demands (Z) depend only on nominal prices measured in the domestic-currency units of exporters and importers (Px, Pz) and that cross-price effects among markets are ignored:

Letting S be the nominal exchange rate and T the trade balance (and current account), equations (10.21) and (10.21a) describe the market-clearing conditions for imports (Z) and exports (X). Equation (10.22) shows the trade balance, and equations (10.23) and (10.23a) show the law of one price for each good. If S increases, denoting a devaluation, the market-clearing domestic-currency price of each good rises, increasing the volume of trade in the home good (exports) and reducing the volume of trade in the foreign good (imports). Consequently, the net effect on the trade balance is ambiguous. Although the domestic-currency value of exports increases, the domestic-currency value of its imports may rise or fall, depending on demand and supply elasticities. For the special case in which export supplies are infinitely elastic, a devaluation of the domestic-currency unit (an increase in S) improves the trade balance if and only if the sum of the two import demand elasticities (ϑandϑ*) is greater than unity. The inequality (1 – ϑ – ϑ*) < 0 is known as the Marshall-Lerner condition (Bickerdike, 1920; Robinson, 1937; Metzler, 1949).

The elasticity approach offers only a partial-equilibrium framework for analyzing the effects of exchange rate changes on the balance of payments, and it ignores the effect of asset changes and the difference between domestic production and domestic absorption—the counterparts of trade imbalances. Furthermore, import demand and export supply functions are a function of their own prices, rather than of relative prices and appropriate scale variables, such as real income and productive capacity (Isard, 1995).

A more integrated approach, known as the absorption approach, emphasizes that a devaluation increases home output and reduces foreign output by lowering the relative price of the home good and thereby inducing a shift in the composition of demand. The effect of the devaluation on the trade balance, however, is smaller than what it might be using the elasticity approach, given the feedback effects on trade flows of higher output and income in the home country (Robinson, 1937; Harberger, 1950; Meade, 1951; Alexander, 1952). The main drawback of this approach is its static (as opposed to intertemporal) optimization method of national income analysis. This approach received new recognition after the Bretton Woods system collapsed in the early 1970s, renewing interest in the time profiles of the responses of traded-goods prices and quantities to changes in the exchange rate. The j-curve concept was also coined to illustrate that, after a devaluation, a country’s trade balance (measured in domestic-currency units) can be expected to become worse before it becomes better, since import prices rise more rapidly than export prices and trade volumes respond only with a lag.

Early Models of Stabilization Policy for an Open Economy

Following Meade (1951) and Swan (1963), the simultaneous analysis of internal and external balance became the most common method of analyzing the relationship between the balance of payments and the exchange rate. In Swan’s analysis, internal balance (defined as full employment, or N) and external balance (defined as balance of payments equilibrium, or F) can each be attained with various combinations of aggregate domestic real expenditure (absorption, or A) and the prices of foreign relative to home goods (the real exchange rate):

The first equation, which has a negative slope, indicates that absorption and the real exchange rate must change in opposite directions to maintain full employment. The second, which has a positive slope, indicates that the balance of payments improves with an increase in the real exchange rate and deteriorates with a rise in absorption. Over time, the curves in Figure 10.1 will shift, and short-run disturbances may move the economy away from internal or external balance (or both). Within Swan’s framework,27 the challenge to policymakers is to design policies—including expenditure-reducing and expenditure-switching policies (primarily exchange rate policy)—that affect absorption and relative prices. In this way the economy stays as close as possible to the intersection of the two curves—that is, where internal and external equilibria are achieved simultaneously (Isard, 1995).

Figure 10.1.Determination of Employment and the Balance of Payments

In the early 1960s, Mundell (1960, 1961a, 1961b, 1962, 1963) and Fleming (1962) began exploring the policy implications of international capital mobility. The Mundell-Fleming model, based on the open-economy extension of the IS-LM model, combines the simple Keynesian framework of the goods and money markets with the assumption that net international capital flows into the economy are positively related to the domestic rate of interest. The model assumes that foreign prices and interest rates are exogenously given. It focuses on the domestic interest rate or money supply as the instrument for monetary policy and on the budget deficit as the basic instrument for fiscal policy. Adding to the IS-LM framework a balance of payments equilibrium curve (FF) similar to Swan’s external balance curve, Mundell (1961a) analyzes equilibrium in terms of domestic income (Y) and the interest rate (I):

where equation (10.27) describes the market-clearing conditions for money.

In Mundell’s framework (see Figure 10.2), the NN curve, along which the excess of home investment over home saving is equal to the trade deficit, and the LL curve, along which the demand for money is equal to the given supply, are drawn with the same slope as the traditional IS and LM curves, respectively. The FF curve, along which the overall balance of payments is zero, has a positive slope.28 While the trade balance depends on domestic income, the overall balance of payments is also affected by the capital account, which depends on the domestic interest rate. The influence of the exchange rate on the balance of payments is not direct but stems from a shift in the NN and FF curves induced by the impact of a change in the real exchange rate. A devaluation of the domestic currency shifts both curves to the right. With an improved trade balance at any level of Y, a lower i is required for balance of payments equilibrium and a higher I for goods market equilibrium.

Figure 10.2.Mundell Model of International Equilibrium

Mundell recognizes that sustaining an unbalanced international payments position is difficult over the long run, since doing so requires a substantial level of foreign exchange reserves in deficit countries and a willingness to make unrequited capital exports in surplus countries. He notes that any secular change in the competitive situation, or a persistent tendency in some countries to inflate at faster rates than other countries, “must eventually bring the day of reckoning” (Mundell, 1961b). Because sustainability requires balance of payments equilibrium in addition to full employment, and given Tinbergen’s principle, both monetary and fiscal policy are used in stabilization policy.29

One of the major conclusions of the Mundell-Fleming model is that the relative effectiveness of monetary and fiscal policies depends on both the existing exchange rate regime and the degree of international capital mobility. Mundell (1963) analyzes the case of perfect capital mobility under both fixed and flexible exchange rates.30 Under a fixed exchange rate system, an increase in the money supply through open market operations creates excess liquidity and exerts downward pressure on interest rates, causing a capital outflow. To prevent the exchange rate from depreciating, central banks intervene in the market, selling foreign exchange and buying domestic money until the money supply is restored to its original level. Thus, monetary policy has no sustainable effect on the level of income, but it does lead to a change in international reserves. An expansionary fiscal policy, conversely, has a multiplier effect on income and no effect on international reserves. The increase in income increases saving, taxes, and imports. The need for higher liquidity in the private sector leads to a capital inflow that offsets the deterioration in the trade balance, so that the balance of payments remains unchanged.

Under a flexible exchange rate system, a monetary expansion has a strong effect on the levels of income and employment, not because it lowers the rate of interest but because it induces a capital outflow, depreciates the exchange rate, and (normally) improves the trade balance. An expansionary fiscal policy, conversely, causes the trade balance to deteriorate without affecting domestic output or employment. In this case, the increase in the demand for goods raises the demand for money (hence the interest rate) and attracts a capital inflow, resulting in an appreciation of the exchange rate and in turn depressing income.

The traditional flow model (Mundell, 1960) has been tested empirically in the following form:

where the hypothesis to be tested is that α1, α2 > 0 and α3 < 0. This model assumes that prices adjust sluggishly—that is, the PPP hypothesis is not imposed. Rising domestic prices and income lead to a deterioration in the current account without affecting capital flows. Thus, the exchange rate must depreciate to improve the current account balance. Assets are imperfect substitutes, so an increase in the domestic interest rate (without a change in the foreign rate) induces capital inflows and an appreciation of the exchange rate.

Asset Equilibrium Models of the Balance of Payments

The primary criticism of the Mundell-Fleming model has been that it conceptualizes the capital account as a flow rather than as a function of the effort of economic agents to adjust asset stocks to their desired levels.31 By the second half of the 1960s, the analysis of exchange rates and the balance of payments entered a new phase with the monetary approach to the balance of payments and the portfolio-balance approach.32 These approaches emphasize the role of money and other assets in determining the balance of payments when the exchange rate is pegged and in determining the exchange rate when the exchange rate is flexible (Frenkel, 1978; Frankel, 1993a). The origin of the monetary approach can be traced to Hume in the eighteenth century and Ricardo in the nineteenth century and was resurrected by Johnson (1956) and Mundell (1968b and 1971).33 Both models were originally formulated for a fixed exchange rate system and provide a convenient framework for analyzing discrete changes in exchange rates.

The Monetary Approach Under Fixed Exchange Rates

The monetary approach focuses on the official settlements balance (that is, the monetary or money account, rather than the balance of trade or the current account).34 The monetary approach considers the imbalance between the demand for and the supply of money as the crucial determinant of balance of payments disequilibria. Indeed, its first general principle is that the approach itself is fundamentally (but not exclusively) a monetary phenomenon.35 The second general principle (as noted) is that the analysis of the balance of payments should center around the supply-of-money process and the demand for money, postulated as a stable function of a small number of macroeconomic variables. Under fixed exchange rates, the balance of payments becomes an additional source for the supply of money, increasing or reducing it according to whether the balance of payments is in surplus or deficit.36 The third general principle is that the monetary approach draws on several models of the adjustment process, since no single model of the process is always appropriate for all countries and all institutional arrangements. The approach combines a generalized theory of long-term behavior with these models (Mussa, 1976). Since the balance of payments is identically equal to the excess of expenditure over income, the analysis of the adjustment process must explicitly specify the mechanism that drives the adjustment of expenditure to income.

The most important policy implication of the monetary approach is that money supply adjusts to money demand through changes in the balance of payments, and hence that the monetary authorities cannot control the total money supply, only its composition. In open economies with a fixed exchange rate regime or any of its variants, balance of payments deficits or surpluses affect the supply of money (except possibly in the short run if the monetary effects of those deficits or surpluses are sterilized). In this scenario, the nominal supply of money is said to be demand determined, since the nominal supply of money adjusts to the nominal demand for money by exporting or importing money through deficits or surpluses in the balance of payments. Therefore, the banking system has no direct control over the nominal supply of money; it can only determine domestic credit (that is, one of the sources of supply of money). This is in strong contrast to the closed-economy and flexible exchange rate cases, where the rest of the economy cannot change the nominal supply of money. Another important policy implication of this approach is that changes in exchange rate parity affect the balance of payments only if the parity affects the equilibrium in the money market.

The monetary approach to the balance of payments is often formulated for a small country in relation to the rest of the world, with which it maintains a fixed exchange rate system. It is formulated in general-equilibrium terms, incorporating both real and monetary sectors. Full equilibrium is achieved when stocks and flows are in equilibrium in both markets. The two basic postulates of the quantity theory of money are incorporated into the model: first, that money has no influence on real economic variables, at least in the long run (neutrality postulate), and second, that the level of prices will change in the same proportion as the quantity of money (equiproportionate postulate). A stylized version consists of a money supply equation (M) embodying a domestic component (D) and a foreign component expressed in foreign currency (R), and a stable money demand function (L), formulated in the classic way—that is, with real income (Y) exogenous to the system (constant at the full employment level) and all prices flexible. Perfect arbitrage is assumed in both commodity and financial markets, and, since the exchange rate is fixed, the price level and the rate of interest in the small country reflect those prevailing in the rest of the world.37 That is:

Models of the monetary approach derive the structural equation of the model (that is, the reserve flow or balance of payments equation) from the money market equilibrium condition. The exchange rate is fixed and, for simplicity, equal to unity (S = 1). Differentiating equation (10.34) logarithmically and finding first differences generates percentage changes in international reserves (or the balance of payments, r) and in domestic credit, d, as follows:

where, in general, x = d log X = (δX/δt)/X and t = SR/(SR + D), and η and φ are the elasticities of money demand with respect to income and the interest rate.

The monetary approach challenged the conventional wisdom that a change in the exchange rate affects the balance of payments, holding that it affects the balance of payments only insofar as it creates an imbalance in the money market. A large accumulation of or a fall in reserves exerts pressure on the exchange rate parity.

The monetary approach may also be formulated to include financial assets other than money that economic agents regard as perfect substitutes. Ruling out capital mobility, Frenkel and Mussa (1985) consider the case of a small, open economy facing specific world relative prices for all (tradable) goods produced and consumed by domestic residents.38 Using the Hicksian aggregate principle, they measure domestic real income (equal to domestic output), Y, and domestic real expenditure or absorption, A, in common units of a composite tradable good. Y is constant at the full employment level, and domestic real expenditure depends on domestic real income, the domestic real interest rate, r, and the real value of privately held domestic assets, W:

Private residents of the home country hold domestic assets consisting of money, M, and domestic interest-bearing securities, BD, which are denominated in units of domestic currency:39

The real value of these assets depends on the domestic price level, P, which is equal to the foreign price level, P*, multiplied by the exchange rate, S:

Assuming for simplicity that the money multiplier is unity, the domestic money supply is high-powered money issued by the domestic central bank and is equal to the sum of the domestic-money value of the foreign exchange reserves of the central bank, SR, domestic securities held by the central bank, BDc,40 and the fiat issue (or “net worth”)41 of the central bank, NW:

The home country’s real trade balance, T, must equal the excess of real income (equal to domestic output) over domestic real expenditure (Alexander, 1952):

Since, by assumption, trade imbalances cannot be financed with private capital flows or with changes in the private holdings of foreign monies, they must be financed with drawdowns of international reserves, made by the central bank to maintain the fixed exchange rate. The magnitude of this reserve flow is shown by

where ΔR = dR/dt. Based on equations (10.38) and (10.39), and under the assumption that BDC and NW are held constant, then

This relationship is analogous to one of the central tenets of Hume’s price-specie-flow mechanism—that trade deficits cause an outflow of money (gold), whereas trade surpluses create an inflow.42

The Portfolio-Balance Approach Under Fixed Exchange Rates

Like the monetary approach, the portfolio balance approach focuses on the link between balance of payments flows and adjustments to asset stocks. This approach holds that models of the capital account should be rooted in behavioral models of the supplies of and demands for portfolio stocks.43 Unlike the monetary approach, the portfolio balance approach assumes that portfolio holders are risk averse, hold assets other than money, and regard domestic and foreign assets as imperfect substitutes.44 Since the UIP condition holds only when assets are perfect substitutes, the interest rate on domestic bonds differs from the interest rate on foreign bonds plus the expected rate of change in the exchange rate.

Assuming that policymakers determine asset stocks and that interest rates and exchange rates (current and expected future) are the endogenous variables that adjust to clear the markets, the portfolio balance approach focuses on the behavior of the differential between the expected rates of return of home and foreign bonds, expressed in domestic currency.45 The differential is the same for domestic and foreign bond holders. Following Dooley and Isard (1983),

where it is the nominal interest rate, δζ is the expected rate of depreciation in the domestic currency, and the asterisk (*) captures foreign country variables. This equation differs from equation (10.19) in an important way. Whereas I and I* in equation (10.19) refer to interest rates on claims that are identical except in currency denomination and interest rates, in equation (10.43) they refer to interest rates on claims against governments of countries with different credit risks. Whereas ξ in equation (10.19) represents the premium or expected yield differential for incurring exchange risk associated with holding assets denominated in different currencies, O represents the premium for incurring both exchange risk and the difference in credit risk. The magnitude of the risk premiums that are required to clear the financial markets depends on the relative stocks of the different types of net claims on other governments (outside assets).

Exchange Rate Dynamics in the Transition to Flexible Exchange Rates

As pointed out by Frenkel and Mussa (1985), the shift to a system of floating exchange rates among the major currencies in 1973 was accompanied by a corresponding shift in research interest away from the balance of payments to the economic determinants of the behavior of exchange rates. The unifying theme in much of this research was the asset market approach to exchange rates, which, as discussed earlier, emphasizes that conditions for equilibrium in the market for stocks of assets, especially national monies, are the primary determinant of the behavior of exchange rates.

Mundell (1968a) and Johnson (1976a) have suggested that the monetary approach, which was once applied almost entirely to countries with fixed exchange rate regimes, can also be applied in countries with flexible regimes (Bilson, 1979). Frenkel and Johnson (1978) explain that the monetary approach can also be used to analyze the case of a floating rate world by shifting the focus of the analysis from the determination of the balance of payments to the determination of the exchange rate. They note that this switch in emphasis was already clear to Gustav Cassel, who saw PPP as determining either a nation’s price level via its exchange rate under a fixed exchange rate system, or its exchange rate via its domestic money supply under a floating rate system.

This section focuses on the transition from fixed to flexible exchange rates by presenting the simplest model of exchange rate determination and a model of exchange rate market pressure—an adaptation of the monetary approach in the context of a flexible exchange rate. The section also examines the role of expectations, which under flexible exchange rates strongly influence nominal interest rates. Finally, it presents the Dornbusch exchange rate dynamics model, which allows for short-run deviations from PPP to illustrate the role of consistent expectations, sticky prices, and exchange rate overshooting.

A Simple Monetary Model of Exchange Rate Determination

Bilson (1979) provides a simple specification of monetary models of exchange rate determination that is the foundation for later models. It consists of the following three equations:46

where the variables are defined as before and asterisks indicate foreign country variables. Under flexible exchange rates, the first two equations determine the domestic and foreign price levels,47 leaving the third equation to determine the exchange rate.48 The reduced-form solution for the exchange rate in this simple model is

This formulation clearly illustrates the position taken by Frenkel (1976), Mussa (1976), and others that the exchange rate, being the relative price of two assets (monies), is determined by the relative supply and relative demand for the two currencies.49 However, because the simple model does not provide the link among exchange rates, interest rates, and the exogenous variables, it limits the usefulness of the monetary model for policy and forecasting purposes.

The Girton-Roper Model of Exchange Market Pressure

In the late 1970s, Girton and Roper (1977) developed a model of exchange market pressure that is based on the monetary approach developed in equation (10.35) and tested it for an earlier Canadian experience with a managed float (1952–62).50 They used the model to explain exchange rate movements and changes in official reserve holdings and to determine the volume of intervention necessary to achieve a certain exchange rate target. Connolly and da Silveira (1979) adapted the model to small economies and tested it for Brazil in the following form:51

The model predicts that any disequilibrium in the market for money will exert pressure on the exchange rate and the level of international reserves. Any excess supply of money will cause a depreciation of the exchange rate, a fall in reserves, or more likely a combination of the two.

The Role of Expectations

Under flexible exchange rates, nominal interest rates are strongly influenced by exchange rate expectations. Earlier models of exchange rate determination assumed that exchange rate expectations were based on the current or past values of relevant economic variables. Exchange rate expectations were often assumed to be static, with the expected future spot rate proxied by the current spot rate or the prevailing forward rate. These proxies, however, provided very poor predictions of the exchange rates that were observed ex post and suggested that exchange rate expectations had to be related to expectations of other relevant variables in a forward-looking manner. Revisions in exchange rate expectations in response to news about relevant economic or political variables explain much of the observed ex post variation in spot and forward rates (Isard, 1980, 1983, 1995; Frenkel, 1981b; Dornbusch 1980; Mussa, 1979).

Forward-looking models first assumed that the realized ex post values of spot exchange rates provided unbiased measures of ex ante exchange rate expectations. In some cases, it was even assumed that expectations exhibited perfect foresight. But this assumption was obviously unsatisfactory, since, if foresight were either perfect or unbiased, forward exchange rates could not have been highly inaccurate and apparently biased predictors of future spot rates. In later models, expectations about exchange rates were explicitly related to expectations about exogenous variables in the model, with the relationship constrained to keep it consistent with the hypothesized structures of the models (Isard, 1995).

Consistent Expectations and Sticky Prices: Dornbusch (1976)

The objective of the Dornbusch exchange rate dynamics model is to develop a theory that not only accounts for the observed large fluctuations in exchange rates but also establishes that these movements are in line with rational expectations (Dornbusch, 1976). The model differs from preceding monetary models in that it accounts explicitly for short-run deviations from PPP. The exchange rate jumps instantaneously in response to new economic or political information, whereas national price levels are constrained to be nonjumping variables that are slow to adjust. In this model, PPP is retained as a long-run proposition, and the UIP condition provides the primary link among international financial markets (Bilson, 1979; Isard, 1995).

The Dornbusch overshooting model may be specified as follows:52


where it and it* are (as before) the domestic and foreign nominal interest rates; st is the logarithm of the spot exchange rate measured in domestic currency per unit of foreign currency; seq is the long-run equilibrium level of st; δte is the expected rate of change in st; and mt. pt, and pt* are the logarithms of the domestic money supply and the domestic and foreign price levels; Δpt is the rate of change in pt; yt is the level of domestic real income (output); σ, ε, η, φ, and ω are constant parameters; and θ is a model-consistent function of other parameters.

The model consists of an uncovered interest parity assumption, equation (10.49); an equation relating the expected rate of depreciation in the domestic currency to the gap between the current and equilibrium exchange rates, equation (10.50); a money market-clearing condition in which the demand for real money balances depends positively on real income and negatively on the nominal interest rate, equation (10.51); a goods market-clearing condition, in which the demand for domestic output is positively related to both domestic real income and the relative price of foreign output and negatively related to the domestic interest rate, equation (10.52); and an equation representing the assumption about price adjustment, equation (10.53).

The most important result of this model is that, in the process of adjusting to an unanticipated change in the money supply, the exchange rate will overshoot its equilibrium value in the short run. This result is illustrated in Figure 10.3 by the negatively sloped QQ line, which represents the set of combinations of p and s that clear the money and goods markets simultaneously.53 Starting from a position of steady-state equilibrium at (S0, p0), with exogenous variables (Ψ, p* and I*) unchanged, a permanent increase in the money supply shifts the new steady-state equilibrium along a positively sloped 45° line54 through (s0, P0), increasing the steady-state value of P by the same amount as the (logarithm of the) money supply. With the QQ curve shifting upward to Q’Q’, the new steady-state equilibrium becomes (s2, p2). Since prices adjust only gradually, the impact of the monetary shock is to shift the economy to (s1, P0). The sudden depreciation of the domestic currency (from S0 to s1) coincides with a decline in the domestic interest rate (necessary to clear the money market) and stimulates domestic output, setting in motion the price-adjustment process. The resulting positive interest rate differential gives rise to expectations that the initial jump depreciation of the domestic currency will be followed by a period of appreciation.

Figure 10.3.Dornbusch Model of Exchange Rate Overshooting

As Isard (1995, page 124) points out:

The Dornbusch model has played a dominant role in shaping the literature on exchange rate dynamics through the early 1990s. Its prominence has reflected both the analytic elegance of the model and empirical evidence that strongly rejects models based on the classical assumption of perfectly flexible prices. At the same time, two handicaps of the Dornbusch model—in particular, its ad hoc specification of the price determination process and its failure to provide an explicit role for the current account in exchange rate determination—may have contributed to its poor empirical performance … and have greatly limited its relevance in policy-oriented discussions of exchange rate dynamics.55

The Modern Asset Market Approach to Exchange Rate Determination

The theoretical and empirical literature on the asset market view of exchange rates has expanded extensively. As pointed out by Frankel (1993b), the popularity of this view can be attributed to the compelling realism of both its theoretical assumption and its empirical implications for today’s world. The theoretical assumption shared by all asset market models is the absence of substantial transaction costs, capital controls, or other impediments to the flow of capital among countries, an assumption referred to as perfect capital mobility. The exchange rate must therefore adjust instantaneously to equilibrate the international demand for stocks of national assets (rather than just the international demand for flows of national goods, as in the more traditional view).56 The empirical implication is that floating exchange rates exhibit more variability than can be explained by the underlying determinants.

The Monetary Approach Under Flexible Exchange Rates

The monetary approach to exchange rates consists of two very different types of models that have distinct implications for the relationship between the exchange rate and the interest rate. In the flexible-price models (also referred to as Chicago or monetarist models), changes in the nominal interest rate reflect changes in the expected inflation rate. Thus, a rise in the domestic interest rate in relation to the foreign rate indicates that the domestic currency is expected to lose value through inflation and depreciation. This effect implies a positive relationship between the exchange rate and the interest rate differential. In sticky-price models (also referred to as Keynesian models), prices remain sticky for at least the short term, and changes in the nominal interest rate thus reflect changes in the stance of monetary policy. A rise in domestic interest rates in relation to foreign rates indicates a tightening of the monetary stance and attracts a capital inflow, causing the domestic currency to appreciate instantaneously. Models of this type therefore show a negative relationship between the exchange rate and the nominal interest differential (Frankel, 1979).57

Flexible-Price Models

Flexible-price models (Frenkel, 1976; Bilson, 1978b, 1978c) assume that PPP holds in the long run. Therefore,

with variables defined in log form as they were for equations (10.49) through (10.53).58 These models also assume that price levels are consistent with money market equilibrium conditions in domestic and foreign countries, where the demand for money is a stable and predictable function of income and the interest rate:59

where η and η* are the income elasticities of the demand for real money balances, whereas φ and φ* are the interest semi-elasticities in the domestic and foreign countries, respectively. Assuming that the two money demand functions are identical, combining equations (10.54) and (10.55) and adding a disturbance term allows the flexible-price, or monetarist, model of exchange rate determination60 to be tested in the following form:61

where the hypothesis to be tested is that α1, α3 < 0 and α2 < 0. The flexible-price models assume that assets are perfect substitutes, that PPP holds, and that the money market clears instantaneously.62 Consequently, an increase in the demand for money (an increase in income or a decline in interest rates) appreciates the nominal exchange rate, whereas an increase in the supply of money causes a depreciation.63 An increase in the domestic interest rate relative to the foreign rate indicates that the domestic currency is expected to lose value through inflation and depreciation.

Sticky-Price Models

As mentioned earlier, the sticky-price model was originally developed by Dornbusch (1976), who abandoned the premise of continuous PPP. A few years later, Frankel (1979) made the first attempt to fit the sticky-price model to empirical data. The model shares with the Dornbusch (Keynesian) model the assumption that sticky prices in goods markets create a difference between the short and the long run. It shares with the flexible-price (monetarist) model an attention to long-run monetary equilibrium.

Frankel modifies Dornbusch’s assumptions—equations (10.49) through (10.53)—to allow for differences in secular rates of inflation. In particular, letting ρ and ρ* denote expectations held at time t about the long-run rates of inflation in the two countries, equation (10.50) becomes

indicating that the expected rate of exchange rate depreciation is a function of the gap between the current spot rate and an equilibrium rate, seq, and of the expected long-run inflation differential between the domestic economy and foreign countries. In the short run, when the exchange rate deviates from its equilibrium path, the gap is expected to close with a speed of adjustment of θ. In the long run, when the exchange rate lies on its equilibrium path, it is expected to increase at (ρ - ρ*). The equilibrium value of s is conditional on maintaining the respective money supplies and income levels at their current values. Combining equation (10.57) with the UIP assumption in equation (10.49) yields

showing that the gap between the exchange rate and its equilibrium value is proportional to the real interest differential. The intuitive explanation, Frankel points out, is that when a tight domestic monetary policy causes the nominal interest differential to rise above its equilibrium level, an incipient capital inflow causes the currency to depreciate proportionately from its equilibrium level. The exchange rate then overshoots its equilibrium level by an amount proportional to the real interest rate differential—the nominal interest rate differential minus the expected inflation differential.

In the long run s = seq, and therefore II* = ρ – ρ*. Substituting for the long-run equilibrium value in equation (10.58) and assuming that the current equilibrium money supplies and income levels are given by their current actual levels, Frankel determines the spot exchange rate as a function of the relative money supply, relative income level, nominal interest differential, and expected long-run inflation differential. Sticky-price or Keynesian models of exchange rate determination have been tested in the following form:

where the hypothesis to be tested is that α1, α4 > 0 and α2, α3 < 0. The sticky-price assumption means that a contraction in the domestic money supply relative to money demand (without a corresponding fall in prices) will cause the domestic interest rate to rise relative to the foreign rate. The higher rates will spur a capital inflow, causing the domestic currency to appreciate. Thus, this model, unlike the flexible-price version, postulates a negative relationship between the exchange rate and the nominal interest rate differential.

The Portfolio-Balance Models Under Flexible Exchange Rates

According to Frenkel and Mussa (1985), analyses of exchange rate determination within the monetary framework do not explicitly emphasize the stocks of other assets. According to the monetary model, changes in the stocks of alternative assets generate exchange rate changes only by altering the various rates of return affecting the demand for money. In the late 1970s and early 1980s, the portfolio-balance approach redesigned macroeconomic theory for open economies. Portfolio-balance models of the kind discussed earlier seemed a promising way to explain the 1977–78 dollar depreciation, which was giving the monetary models poor empirical results (Frankel, 1993b). Contrary to the monetary approach, the portfolio-balance approach assumes that differences in various risks make domestic and foreign assets imperfect substitutes and emphasizes the limited degree of substitutability among alternative assets. According to this approach, financial markets are in equilibrium when the available stocks of national monies and other financial assets are equal to the stock demands for these assets based on current wealth. Wealth accumulation continues only until current wealth reaches its desired level. The relative quantities of the various assets and the rate at which these assets accumulate exert profound first-order effects on the exchange rate. Thus, although these models were originally developed to study movements of financial capital, variations in interest rates, and changes in stocks of international reserves under fixed exchange rates, they were quickly adapted to study movements of financial capital, variations in interest rates, and changes in the exchange rate under flexible exchange rate regimes (Branson and Henderson, 1985; Frenkel and Mussa, 1985),

As noted by Frenkel and Mussa (1985), equality between the rate at which assets accumulate and the current account of the balance of payments provides a dynamic link between the current account and the exchange rate. Consequently, portfolio-balance models have typically linked the exchange rate to the current account64 and have been tested with

where ∫CCA and ∫CCA* represent the cumulative current accounts of the two countries, and the assumption to be tested is that α1, α4, α5 > 0 and α2, α3, α6 < 0.

The above formulation by Hooper and Morton (1982) can be interpreted as an extension of the sticky-price monetary model that accounts for the existence of risk. In this model, assets are not perfect substitutes, and the time-varying (unobserved) risk premium is a function of the current account. An alternative explanation comes from Meese and Rogoff (1983a and 1983b), who argue that the current account variable accounts for changes in the long-run real exchange rate. This explanation holds because current account imbalances redistribute wealth internationally and, other things being equal, affect expenditure, income, and the current account at the national level. In turn, the long-run real exchange rate (that is, the real exchange rate that is consistent with long-run current account balance) is itself affected.

Empirical Evidence on the Asset Approach

Examining empirical evidence on monetary models, Frenkel (1976) finds strong support for the flexible-price model for the deutsche mark-U.S. dollar exchange rate during the German hyperinflation of the 1920s. The subsequent accumulation of data during the 1970s allowed the model to be estimated for the major exchange rates during the recent float, and these early studies were also broadly supportive of the flexible-price model (MacDonald and Taylor, 1992; Bilson, 1978a; Dornbusch, 1979). By 1980, however, the flexible-price model stopped providing a good explanation for variations in exchange rates. The estimated equations provided poor fits, and the coefficients exhibited the wrong signs (Frankel, 1993b, 1982a).65 Some authors attribute these results to econometric misspecification, while others argue that large current account deficits or surpluses during the period generated important wealth effects that are not adequately captured in the simple monetary models.

MacDonald and Taylor (1992) also report weak evidence for the sticky-price model when the data period is extended beyond the late 1970s. For instance, the model suggests that proportional variation exists between the real exchange rate and the real interest rate differential.66 But several studies have failed to find evidence of cointegration (Edison and Pauls, 1993; Meese and Rogoff, 1988). Some researchers find that these results may have been caused by omitted variables that are determinants of the equilibrium real exchange rate or the risk premium, and that a significant positive correlation may in fact exist (Throop, 1993; Baxter, 1994).

Portfolio-balance models have been subject to less empirical testing than monetary models. Taylor (1995) attributed the disparity to the difficulty of mapping theoretical portfolio-balance models into real-world financial data and to methodological constraints, such as the types of nonmoney assets to be included.67 In general, the empirical literature has uncovered weak support, at best, for the hypothesis that risk premiums vary over time in the manner suggested by portfolio-balance models (Isard, 1995).

An alternative way to examine the empirical validity of models of exchange rate determination is to examine their out-of-sample forecasting performance. In a seminal paper, Meese and Rogoff (1983a) compare the out-of-sample forecasts of three asset models of exchange rate determination that had been subjected to extensive in-sample empirical testing with forecasts produced by a random walk model.68 They conclude that none of the asset market exchange rate models outperformed the simple random walk, despite the fact that actual, rather than forecast, data are used to purge all uncertainty about the future path of explanatory variables from all of the models. Meese and Rogoff (1988) argue that more efficient estimation techniques are unlikely to yield better estimates. They believe that the breakdown of empirical exchange rate models may have been caused by volatile time-varying risk premiums, volatile real exchange rates, or poor measurement of inflationary expectations. But they posit that the main problem is the money demand specifications and, thus, that improving the empirical testing of money demand equations will improve the estimation of exchange rate determination models.

In the early 1980s the field of exchange rate determination entered a period of deep pessimism, epitomized by the findings of Meese and Rogoff (1983a, 1983b) that models based on fundamentals cannot outperform a random walk in an out-of-sample forecasting exercise of equation (10.60), despite the fact that all of the models have the benefit of using actual (rather than forecast) data for the right-hand-side variables. Frenkel and Rose (1995) argue that the Meese and Rogoff analysis of short horizons (less than 36 months) has never been convincingly overturned or explained. For this reason, they advocate abandoning traditional fundamentals and studying the market microstructure of the foreign exchange market—that is, interbank behavior—to obtain an understanding of short-run exchange rate behavior. MacDonald (1997a) argues that such pessimism is unfounded and that fundamentals can be used to say something positive about where a currency stands in relation to its equilibrium value.69 He attributes the renewed interest in modeling long-run, or equilibrium, exchange rates to developments in the time-series literature rather than to any new theoretical development.70 Summarizing the recent float experience, he reports considerable evidence of weak PPP and little evidence of the strong form. Adjustment speeds are very slow for this period (half-lives of approximately 20 years). Extending the span of data produces evidence that favors strong-form PPP. MacDonald argues that an adjustment half-life of three to four years, however, is still too slow to be consistent with price stickiness. Monetary models, being extensions of PPP, generally confirm the PPP results, although half-lives are noticeably faster. In his view, obtaining models that have fast adjustment speeds and sensible long-run properties and that lend themselves to forecasting necessitates recognizing the real determinants of exchange rates explicitly, either by taking a very reduced-form approach or by modeling the fundamental determinants of real rates.71


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For a discussion of the origins of PPP theory, see Officer (1982), Dornbusch (1987), and Rogoff (1996).

In a two-country setting, and given the existence of arbitrage in goods markets, the law of one price should hold for each homogeneous traded good. Absolute PPP is the result of summing up the prices of all traded goods in each country and assigning the same weight to each price.

The general consensus is that the dynamic version of PPP is empirically valid.

Edwards (1988, 1989) discusses the economics of real exchange rates.

Frenkel (1976) notes that although most authors recognize that prices and exchange rates are determined simultaneously, a minority argue that a causal relationship exists between prices and exchange rates. Cassel (1921) claims that causality moves from prices to the exchange rate, whereas Einzig (1937) claims the opposite.

An important difference exists between PPP and the law of one price. Whereas the law of one price applies to an individual commodity, PPP applies to the general price level, which is a composite of the prices of all the commodities in the typical consumption basket.

A random walk is defined as follows: Xt = Xt-1 + εt, where εti.i.d (0, σ2), Isard (1995) studied quarterly data on bilateral real exchange rates for the 1970–94 period for Germany. Japan, the United Kingdom, and the United States based on different price indices (the CPI, the WPI, the GDP deflator, and unit labor cost and export price indices). He finds large and persistent deviations of the real exchange rate indices from their mean in the short run that resemble a random walk.

In the mid-1980s, efforts were also made to explain the secular behavior of nominal exchange rates relative to ratios of national price levels in terms of the Balassa-Samuelson effect, where, in essence, the maintained hypothesis was that long-term PPP held only for the tradable component of national price indices (Isard, 1995). Froot and Rogoff (1995) concluded that the empirical evidence in support of a Balassa-Samuelson effect was weak, particularly when real exchange rates were compared across industrial countries in the post-Bretton Woods period.

Equation (10.7) was traditionally tested with ordinary and generalized least squares. In recent years there has been renewed interest in modeling long-run, or equilibrium, exchange rates. Much of this research has been stimulated by developments in the time-series literature. Advances in econometrics for nonstationarv time series have shown that this type of testing is inadequate when time trends are associated with the home and foreign price levels. For cointegration-based tests, see MacDonald (1997a), MacDonald and Taylor (1993), Patel (1990), and Froot and Rogoff (1995). Patel argues that the distinction between weak and strong PPP is important, because transportation costs and price weights differ across countries. He maintains that no hypothesis should be made about the specific values of β1 and β2 except that they are positive and negative, respectively.

For absolute PPP, variables are defined as price levels; for relative PPP, they are defined as first differences.

The null hypothesis that the real exchange rate behaves like a random walk is equivalent to a test for a unit root in real exchange rates.

This evidence has been examined with augmented Dickey-Fuller tests. Univariate unit root tests, however, have shown comparatively low power to reject the null when it is in fact false, especially when the autoregressive component F is close to unity. MacDonald (1997a) discusses alternative tests and their empirical validity.

Froot and Rogoff (1995) note that consensus estimates put the half-life of deviations from PPP at about four years for exchange rates among industrial countries. Hegwood and Papell (1998) challenge the findings that support long-run PPP by rejecting unit roots in favor of stationarity and by rejecting the argument that the speed of convergence to PPP is very slow (the half-lives of PPP deviations—the expected time required for a PPP deviation to decay by 50 percent—have been estimated at between three and five years). They find that the real exchange rate is stationary—but around a mean that is subject to occasional structural changes. They call this result quasi-PPP. They also find that reversion to the changing mean is much faster than reversion to a fixed mean.

Also see a previous study by MacDonald and Taylor (1992).

Some researchers have argued that the data coverage period for the recent float may he too short to provide power in the normal statistical tests for the stationarity of the real exchange rate (Frankel, 1990). By extending the sample, some studies have rejected the random walk hypothesis for the real exchange rate (for example, Abuaf and Jorion, 1990). Using sterling-franc exchange rate data spanning two centuries up to 1990, Lothian and Taylor (1995) found strong evidence in favor of mean reversion in the real exchange rate. Flood and Taylor (1996) also found strong support for mean reversion toward long-run PPP, based on panel data for 21 industrial countries over the floating rate period.

By providing a mechanism for exchanging domestic for foreign currency (or vice versa) at a future date at a prespecified exchange rate, forward trading eliminates the uncertainty associated with future exchange transactions.

The discount is equal to the difference between the forward and spot rates (ftSt).

Exchange rates covering on-the-spot trading are called spot exchange rates, although they may become effective only two days later, after payment instructions (such as checks) clear through the banking system. The exchange rates quoted in transactions specifying a value date further away than two days are called forward exchange rates. Unfortunately, not all currencies are traded in a forward exchange market.

Keynes, however, was aware that, in addition to differences in currency denomination and interest rates, assets differed according to risk factors. In the 1920s, the high risk of financial trouble or political disturbances could lead to a debt moratorium or the imposition of exchange controls. More recent innovations in the financial markets have generated financial assets that differ only according to their currency denomination and interest rates and are subject to the same credit risks, capital controls, and explicit taxation.

The CIP hypothesis expresses a simultaneous relationship. Within an organization, traders may price exchange rates against interest rates, and decision makers may use the spot-forward spread to set interest rates. The question is which of these two forces is dominant. The consensus seems to be that it is the former: forward rates are essentially set as a residual after interest rates have been set. This is the cambist, or ban kers’, view of the determination of the forward rate, which essentially implies that the CIP condition becomes an identity, rather than a behavioral relationship. The cambist view contrasts with the so-called academic view, which argues that the forward rate equals the expected spot rate or the expected spot rate plus a time-varying risk premium.

In other words, to borrow sterling, convert spot into dollars, and arrange forward to reconvert the dollar proceeds back into sterling.

Frankel and Rose (1995) provide a recent survey of work on news and foreign exchange markets.

This section summarizes the discussion in Isard (1995).

Several studies have used survey data to examine the issue of bias. To do so, they essentially take survey-based measures of expectations and try to attribute a proportion of the β1 coefficient to a time-varying risk premium and a proportion 1 – β1 to expectational failure (to such effects as the peso problem, rational bubbles, or simple irrationality). Survey data studies have also been used to analyze the formation of expectations in foreign exchange markets (that is, whether they are extrapolative, adaptive, and so forth) and to address the importance of heterogeneity in the foreign exchange market by examining the expectations of individual traders. Evidence of heterogeneity has been found, suggesting that it is an important building block for the usefulness of market microstructure theories. Tagaki (1991) and MacDonald (1997b) examine the survey literature.

Another possible explanation for prediction bias is that estimates of β1 in equation (10.17) may be biased because such equations have not been estimated simultaneously with a second relationship between the interest differential and the change in the exchange rate. This explanation is suggested by the fact that the monetary authorities of most industrial countries rely on short-term interest rates as the policy instrument for responding to undesired exchange rate movements (Isard, 1988; McCallum, 1994). The prediction bias has also been related to self-confirming expectations of rational market participants (rather than fundamentals) and referred to as rational bubbles (Meese, 1986). This possibility is considered more logical than an empirical phenomenon (Obstfeld and Rogoff, 1986; Frankel and Rose, 1995). The possibility of rational bubbles is important to recognize, however, because it represents a fundamental departure from the view that markets act correctly all the time (Dornbusch, 1987).

H.G. Johnson (1976a) argued that the history of balance of payments theory since the early 1930s has been one of successive approaches that exhibit increasing sophistication: the simple elasticity approach (following the classic paper of Joan Robinson), the absorption approach, the Keynesian multiplier approach, the Keynesian policy approach (pioneered by James Meade), and most recently the monetary approach (stemming from the work of Robert Mundell).

Swan’s analysis was included in a paper presented in 1955 but not published until eight years later.

The slope is positive except in limited cases in which capital is either perfectly mobile or perfectly immobile, in which case the FF curve becomes horizontal or vertical, respectively.

Tinbergen (1952) showed that attaining a given number of independent policy targets requires at least the same number of policy instruments. Simple application of this rule led to the principle of effective market classification, which posits that a system works best if policy instruments respond to the imbalances on which they exert the most direct influence (Mundell, 1960).

Related literature on the optimum currency area began to focus on the characteristics that made it optimal for countries to choose among exchange rate regimes (see Mundell, 1961c).

Taylor (1995) points out that although the Mundell-Fleming model makes an important contribution by integrating asset markets and capital mobility into open-economy macroeconomics, its treatment of asset market equilibrium is inadequate, since the stock-flow implications of changes in the interest rate differential are not worked out. Other critics have also noted that the treatment of asset markets is the main problem with this model. The model implies that the exchange rate can be in equilibrium when a country is running a current account deficit if the domestic interest rate is high enough to maintain an offsetting capital inflow. This implication suggests that there may be a steady accumulation of domestic assets by foreigners (Isard, 1995).

Frenkel and Mussa (1985) point out that the key development in the analysis of the balance of payments in the late 1960s and early 1970s was the theoretical elaboration and empirical testing of the dynamic mechanism of balance of payments adjustment that dated back to Hume’s price-specie-flow mechanism. The dynamic mechanism theory held that changes in asset stocks (especially the money supply) associated with payments imbalances alter the instantaneous equilibrium position of the economy over time, ultimately driving it to a long-run equilibrium at which the payments imbalance is eliminated. Frenkel and Mussa argue that much of the literature on the balance of payments and open-economy macroeconomics of the late 1950s and 1960s either ignores this dynamic mechanism or suppresses it through sterilization, but that it is notoriously present in Mundell’s description of the international disequilibrium system (Mundell, 1961b), now frequently referred to as the Mundell-Fleming model.

The monetary approach to the balance of payments was first developed by Johnson (1956) and Mundell (1963, 1968a, 1968b, and 1968c). In the 1970s a large number of theoretical papers and empirical studies on the monetary approach appeared in various economics journals, many of which were compiled in two separate volumes (Frenkel and Johnson, 1976; IMF, 1977).

This section follows del Castillo (1986).

The monetary approach to analyzing the balance of payments explicitly incorporates the influence of such real variables as levels of income and interest rates.

This holds only if the monetary authorities do not follow sterilization policies. Deficits and surpluses in the balance of payments represent the adjustment of actual to desired money stocks.

This Statement means that prices and interest rates are also exogenous according to the small country assumption.

Frenkel and Mussa (1985) also present a model that accounts for capital mobility.

In the absence of capital mobility, these assets are assumed to be nontradable internationally.

Since interest-bearing securities and national monies are not internationally tradable, the total stock of domestic securities issued by the government is held by either domestic residents or the central bank.

Net worth is the difference between the value of the central bank’s monetary liabilities, M, and the value of its reserves and domestic security holding, SR + BDC.

Extending this analysis to a behavioral model of the balance of payments requires a description of private sector behavior (see Isard, 1995).

Metzler (1951) and Tobin (1969) are credited with developing the portfolio approach.

Perfect substitutability implies that asset holders are indifferent about the composition of their bond portfolios as long as the expected rate of return on the two countries’ bonds is the same when expressed in the same currency unit.

Each government finances its budget deficit entirely by issuing debt denominated in its own currency unit.

The monetary model presented here is essentially an extension of the PPP hypothesis.

If, as pointed out by Frenkel (1976), the role of the exchange rate is to clear the money market by equating the purchasing power of the various currencies, then the relevant measure of PPP should be a consumer price index.

The particular exchange rate regime determines the set of market-clearing variables without fundamentally altering the underlying structure of the model. Under fixed exchange rates, the domestic price level is determined by the PPP condition, so that the first equation determines the size of the domestic money supply through balance of payments surpluses or deficits.

The equilibrium exchange rate is attained when existing stocks of the two monies are held willingly. As part of his doctrinal perspective to exchange rate determination, Frenkel (1976) shows that this view of the exchange rate dates back to classical economics, whereas analysis of the exchange rate based on components of the balance of payments is of relatively recent origin, gaining popularity with the domination of the Keynesian revolution.

Del Castillo (1986) presents more in-depth information on this model.

The Connolly-da Silveira model consists of money supply, money demand, and PPP equations like those in equations (10.30), (10.31), and (10.32). Cardoso and Dornbusch (1980) also found empirical support for this model for Brazil, as did del Castillo (1987) for Uruguay. However, empirical results for Uruguay show that in testing the monetary approach in a managed floating exchange rate system, it is not always appropriate—though it is common practice—to use data for the United States as a proxy for the rest of the world in tests of models of small, open economies. A small country in the world economy, such as Argentina, may become large in relation to its even smaller neighbor. This result provides evidence of what Mundell has referred to as the Gulliver effect. Blejer and Leiderman (1981) estimate a model of the joint determination of the exchange rate, international reserves, and the rate of inflation under a crawling-peg system and test it for Brazil. The predictions of the model about Brazilian data sustained the model’s predictions of the signs and the magnitudes of the different parameters.

This formulation corresponds to the case described in the appendix to Dornbusch (1976).

Isard (1995) provides a rigorous mathematical analysis.

The 45° line may have a different slope in addition to a competitiveness effect if an interest rate effect occurs.

Frankel (1979) used a variant of the Dornbusch overshooting model and found a relatively good fit with the deutsche mark-dollar data of 1974–77.

As pointed out by Frankel (1979) and Frenkel and Mussa (1985), however, this approach does not claim that the exchange rate is determined only in the money (or the asset) market or that only stock considerations matter while flow relationships do not. Clearly, the exchange rate (as with any other price) is determined in general equilibrium by the interaction of flow and stock conditions.

These models assume that there are no restrictions on the international movement of capital and that market forces are the overriding determinants of the exchange rate. Blejer (1978) develops an extension of the monetary approach that applies to countries in which exchange restrictions lead to the emergence of black markets.

The assumption that prices relevant to money market equilibrium are the same as those relevant to PPP can easily be relaxed by allowing the price level to be a weighted average of the prices of nontradable goods and internationally traded goods and letting PPP hold only for tradable goods. This manipulation reveals another important determinant of exchange rates—that is, the relative price structures of the two economies. A rise in the domestic relative price of tradable goods (a loss in competitiveness) raises the exchange rate, depreciating the domestic currency. Frenkel and Mussa (1985) provide a detailed analysis.

This assumption is often behind the poor empirical performance of some of these models.

Equilibrium exchange rate models of the type developed by Stockman (1980) and Lucas (1982) are considered an extension or generalization of the flexible-price monetary models. These models explain real exchange rate movements as a result of real fundamental determinants, such as productivity shocks and changes in tastes (Taylor, 1995; Frankel and Rose, 1995). Target-zone models have also assumed an underlying flexible-price monetary exchange rate framework. Svensson (1992) provides a comprehensive survey of the target-zone literature. See also Krugman and Miller (1992); Isard (1995); Taylor (1995); and Frenkel and Goldstein (1986).

Frenkel (1976) estimates the determinants of the exchange rate during the German hyperinflation, focusing on the role of inflationary expectations and monetary policy.

In this model, nominal exchange rates are driven by the relative excess supply of money. This model may be thought of as an equilibrium relationship, where the nominal interest rate captures expected inflation through the Fisher condition.

Note that the signs for income and interest rates are the opposite of those in the flow model discussed earlier. (See the section on exchange rates and the balance of payments.)

However, this link is not specific to the portfolio-balance model but reflects the implications of the budget constraint. The current account of the balance of payments equals the difference between income and expenditure, and this constraint obviously holds independently of the determinants of portfolio composition. Consequently, any model that accounts for net saving must imply a relationship between the exchange rate and the current account.

Referring to it as the “mvstery of the multiplying marks,” Frankel (1982a) noted that estimates of equations for the dollar-deutsche mark rate often produced coefficients suggesting that increases in Germany’s money supply during this period caused its currency to appreciate.

This implication follows from the basic assumptions of the overshooting model—that is, slowly adjusting prices and UIP—and can be derived by subtracting relative inflation from either side of equation (10.11).

Obstfetd (1990) and EdiSon (1992) provide comprehensive empirical evidence on portfolio-balance models See also Frankel (1983), Rogoff (1984), and Dominguez and Frankel (1993b).

The reduced-form structural models estimated by Meese and Rogoff included the flexible-price monetary model (Frenkel-Bilson), the sticky-price monetary model (Dornbusch-Frankel), and the sticky-price asset model (Hooper-Morton) and can be described as constrained versions of equation (10.60). All three cases are constrained by setting α1 = 1, based on the assumption that the exchange rate exhibits first-degree homogeneity in relative money supplies. The flexible-price monetary model is constrained by the imposition α4 = α5 = α6 = 0, and the sticky-price model by the imposition α5 = α6 + 0.

In his view, a successful exchange rate model should satisfy two criteria. First, there should be a sensible equilibrium relationship consistent with some underlying theoretical or behavioral model. Second, the model should be able to beat a random walk in an out-of-sample forecasting exercise. It is also important to understand the determinants of exchange rates, and particularly equilibrium exchange rates, from both a theoretical and a policy perspective. From a theoretical perspective, it is important to determine whether the equilibrium relationships underpinning theoretical models are empirically supported by the data. From a policy perspective, two issues are particularly important. First, during the recent managed float, overshooting and misalignments of currencies have been frequent and require a policy response. Second, policy decisions are also necessary to determine the appropriate point at which a country joins a target zone system or irrevocably locks its currency into the European Economic and Monetary Union.

MacDonald (1997a), Taylor (1995), and Isard (1995) review the new econometric literature on exchange rate determination.

As MacDonald (1998) points out, the emphasis in the developing country literature tends to lean toward modeling the real determinants of real rates rather than focusing on the PPP and time-series properties of real rates. The best-known traditional study is Edwards (1989). See also Edwards (1988, 1994), Aghevli and others (1991), and Chapter 11 of the present volume.

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