Academic journal article Journal of Economic Issues

Long-Term Exchange Rate Movements: The Role of the Fundamentals in Neoclassical Models of Exchange Rates

Academic journal article Journal of Economic Issues

Long-Term Exchange Rate Movements: The Role of the Fundamentals in Neoclassical Models of Exchange Rates

Article excerpt

The central theme of the neoclassical approach to exchange rates has been that currency prices are determined by the "fundamentals," or those variables that guarantee the efficient operation of the foreign exchange market. This has remained the core concept despite its dismal empirical record. In fact, the only significant shift that failed statistical studies of the proposition have prompted has been the move to focus more intently on those contexts in which fundamentals-based models have worked best' Eric Pentecost's view is typical:

. . . if expectations are driven by charts [i.e., if they are not based on fundamentals], then economists clearly have little if anything to contribute in the short run and should concentrate on developing structural models which can adequately represent the long-run equilibrium exchange rate [Pentecost 1993, 179; bracketed reference added].

It seems that the fundamentals' place in neoclassical research is so deeply entrenched that years of accumulated evidence of its incompatibility with the real-world exchange market have led economists not to change the theory, but to simply focus on those circumstances in which it is least inappropriate.

The Fundamentals in Theory

In the neoclassical approach, fundamental analysis of exchange rates is tied first and foremost to economic efficiency. When currency prices are determined by the fundamentals, we can conclude that world resources will be allocated optimally; conversely, if we can take optimal allocation of world resources as a given, then currency prices must have been determined by the fundamentals. This is tautological, of course, because the fundamentals are defined (though most often implicitly so) as those variables that will guarantee the efficient allocation of resources.

Neoclassical microeconomic theory suggests that perfectly competitive markets promote efficiency:

A close relationship exists between market structure and the extent of economic efficiency achieved. When profit-maximizing firms and utility-maximizing households, with the help of equilibrium prices established in perfect markets, determine the optimum quantities they wish to trade, all conceivable Pareto conditions of economic efficiency come to be fulfilled [Kohler 1982, 447].

Generalizing on this statement and extending its implications to the foreign exchange market lead to the conclusion that, since both perfect markets and fundamental determination of rates lead to optimal allocation of resources, it must be the case that the role of the fundamentals in determining currency prices increases as markets are made more perfect.

Summarizing the logic leading from perfect markets through the fundamentals to optimally allocated resources suggests the following simple schematic:

Perfectly competitive markets [right arrow] Fundamental determination of rates [right arrow] Currency market efficiency [right arrow] Optimal allocation of resources

Perfectly competitive markets allow the rational, optimizing agents in the foreign exchange market to focus on those factors (prices, quantities, tastes, information, etc.) most important to the maximization of their individual utility functions. An efficient market and optimal allocation of resources arise because they are defined as situations in which it is impossible to reallocate resources or redistribute goods in a way that would benefit some economic agents while not hurting others (according to each person's subjective preferences). If all voluntary exchanges have taken place, which should be the case if markets are by nature perfectly competitive and the government has been careful not to disturb the free-market equilibrium, then this should not be a problem. Thus, perfect competition, complemented by free-market policies, leads to economic efficiency and optimal allocation of resources.

What are the fundamentals? They are those factors most important to the maximization of market participants' individual utility functions. …

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