ABSTRACT
In the 1960s the predominant view of the working of the foreign exchange market was that under floating rates, the exchange rate would be determined so as to equalise the flow demand for foreign exchange by importers and the supply by exporters. In contrast to this 'flow theory', the asset market approach stresses that the equilibrium exchange rate is that rate at which the market as a whole is prepared to hold the total· outstanding stocks of assets of different countries. The foreign exchange market is to be viewed like any other highly organised asset market, such as the market in stocks and bonds. We have already implicitly discussed variants of the asset market approach when analysing the current account monetarist models, CAM, and the capital account monetarist models, KAM. In the former the exchange rate is viewed as the relative price of domestic and foreign money and in the latter perfect substitutability between domestic and foreign bonds is usually assumed. (Of course these models also embody assumptions about the behaviour of other. markets, for example the goods market.)
In this chapter we wish to examine the behaviour of the foreign exchange market in a manner similar to that used by economists to analyse the behaviour of other asset mar~ets such as the stock market. Mussa (1979a) notes that since in these 'spot auction' markets, assets are continuously traded and the assets in question are_ durable then: 'the price of an asset is tightly linked to the market's expectation of the future price of that asset. Whenever information is received that alters the market's view of the likely future price of an asset, the current price of that asset immediately reflects that alteration.'
