Fundamental Determinants of Exchange Rates

Fundamental Determinants of Exchange Rates

Fundamental Determinants of Exchange Rates

Fundamental Determinants of Exchange Rates

Synopsis

Existing models fail to explain the large fluctuations in the real exchange rates of most currencies over the past twenty years. The Natural Real Exchange Rate approach (NATREX) taken here offers an alternative paradigm to those which focus on short-run movements of nominal eschange rates, purchasing power parity of the representative agent intertemporal optimization models. Yet it is also neo-classical in its stress upon the accepted fundamentals driving a real economy. It concentrates on the real exchange rate, and explains medium- tolong-run movements in equilibrium real exchange rates in terms of fundamental variables: the productivity of capital and social (public plus private) thrift at home and abroad. The NATREX approach is a family of growth models, each tailored to the characteristics of the countries considered. The authors explain the real international value of the US dollar relativ to the G10 countries, and the US current account. These are two large economies. The model is also applied to small economies, where it explains the real value of the Australian dollar and the Latin American currencies relative to the US dollar. The model is relevant for developing countries where the foreign debt is a concern. Finally, it is applied to two medium-sized economies to explain the bilateral exchange rate between the French franc and the Deutsche Mark. The authors demonstrate both the promise of the NATREX model and its applicability to economies large and small. Alongside the analysis, econometrics, and technical details of these case studies, the introductory chapter explains in accessible terms the rationale behind the approach. The mix of theory and empirical evidence makes this book relevant to academics and advanced graduate students, and to central banks, ministries of finance, and those concerned with the foreign debt of developing countries.

Excerpt

Economists have been dismayed at the failure of extant models to explain exchange-rate movements. These models encounter two basic problems. First, many models concentrate on modelling short-run movements in exchange rates. In the short run, exchange rates are determined largely by speculative capital flows, depending upon expectations. It is very difficult to claim that these expectations are based upon a wide set of fundamentals. Since the 'fundamentals' evolve gradually, short-run movements in exchange rates are largely noise. Second, the real fundamentals are generally ignored by assuming purchasing-power parity, that the mean and variance of the real exchange rate are invariant over time, and that the real exchange rate converges relatively rapidly to the unchanging mean. That is, it is assumed that the real exchange rate is stationary. Very little attempt has been made to explain what economic forces determine the mean. Since the period of floating, it is apparent that the real exchange rates of the major countries are not stationary in the sense defined.

The short-run models of monetary dynamics with rational expectations have given way to the newer representative agent intertemporal optimization models. The newer models have generally not been subject to empirical verification. In the few cases where they have been, they are inconsistent with the evidence. The reasons are that these models make highly restrictive assumptions and their crucial variables are not objectively measurable.

We therefore began thinking of an alternative approach. We ignore the short run and focus upon the medium to longer run. We concentrate upon the real rather than upon the nominal exchange rate. Our fundamentals are productivity of capital and thrift both at home and abroad. We reasoned that since floating, social thrift (which includes both private and public saving) and the productivity of capital were the most important fundamentals determining the longer-run movements in the real exchange rate and capital flows. We needed a manageable, testable model which simultaneously explained the equilibrium real exchange rates and non- speculative capital flows. We called our equilibrium real exchange rate the Natural Real Exchange Rate (NATREX), since it is the . . .

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