ABSTRACT
This paper develops three perspectives on the determination of exchange rates and their interaction with macroeconomic equilibrium and aggregate policies. A long-run view characterizes exchange rate determination in terms of monetary and real factors where the real aspects include an explicit consideration of relative price structures. A short-run or “liquidity” view of the exchange rate emphasizes the role of asset market equilibrium and expectations. A policy view, finally, analyzes the effectiveness of aggregate policies and points out that in the short-run nominal disturbances will tend to be transmitted internationally. The paper concludes with an analysis of dual exchange rate systems as a stabilizing policy in the presence of speculative disturbances.
This paper is concerned with some issues in the theory of flexible exchange rates. Specifically, we study the determinants of the exchange rate, both in the short and long run, the role of capital mobility and speculation in that context, and the scope for the international transmission of disturbances. In discussing the transmission of disturbances particular emphasis is given to the idea that in the short run monetary and price disturbances are not offset by matching exchange rate changes and, for that reason, are spread internationally.
The issues raised in this paper have been, to a large extent, discussed in the literature. We note here, in particular, Mundell (1964, 1968) and Fleming (1962) in their discussion of stabilization policy under flexible exchange rates as well as the subsequent work by Argy & Porter (1972) that formalizes the role of expectations in this context. Work by Black (1973, 1975) has emphasized the role of asset markets in exchange rate determination and a paper by Niehans (1975) has explored the 28interaction of exchange rate expectations and relative price responses to question the effectiveness of monetary policy under flexible rates.
The present paper adds to that strand of literature in that it distinguishes short-run effects of policies, sustained in part by price rigidities and expectational errors, from the longer run effects where relative prices and homogeneity are given emphasis. The aggregation departs from the standard Keynesian model of complete specialization and two traded goods in distinguishing traded goods as a composite commodity and nontraded goods. Such an aggregation is preferred since it breaks the identification of the exchange rate with the terms of trade, introduces scope for a monetary interpretation of the exchange rate and leaves room at the same time for intersectoral considerations.
In Section I we lay out a general equilibrium framework for the discussion of exchange rates from a long-run perspective. The critical assumptions of that theory are purchasing power parity for traded goods and monetary equilibrium. In Section II the assumption of purchasing power parity is relaxed to yield a short-run or “money-market” theory of the exchange rate. In Section III we return to purchasing power parity and investigate the role of speculation in affecting the scope for the international transmission of monetary disturbances and for the operation of monetary and fiscal policy. In Section IV the discussion is extended to a dual exchange rate system.
