The International Monetary System: A Time of Turbulence

By Jacob S. Dreyer; American Enterprise Institute for Public Policy Research | Go to book overview

Commentary

Jacob A. Frenkel

The papers by Thomas D. Willett and by Richard J. Sweeney deal with some of the fundamental issues concerning our recent experience with flexible exchange rates. They deal with the causes and the effects of exchange rate volatility, with the efficiency of the foreign exchange market, and with the purchasing power parity theory. In my remarks I will interpret the evidence concerning exchange rate volatility and purchasing power parities in terms of the theory of exchange rate determination, and I will conclude with a brief discussion concerning the policy implications.1

The central insight of the modern approach to the analysis of exchange rates is the notion that the exchange rate, being the relative price of two durable assets (moneys), can be best analyzed within a framework that is appropriate for the analysis of asset prices. A key characteristic of the price of an asset is its strong dependence on expectations concerning the future. In an efficient market for assets, new information concerning the future is reflected immediately in current prices, thus precluding unexploited profit opportunities from arbitrage. The strong dependence of current prices on expectations about the future is unique to the determination of durable asset prices that are traded in organized exchange; it is not a characteristic of price determi-

I am indebted to the National Science Foundation, grant SOC 78-14480, for financial support. The views expressed are those of the author and not necessarily those of the National Bureau of Economic Research.

____________________
1
For a. further elaboration, see Michael L. Mussa, "Empirical Regularities in the Behavior of Exchange Rates and Theories of the Foreign Exchange Market", Carnegie-Rochester Conference Series on Public Policy, vol. 11, supplement to Journal of Monetary Economics ( 1979), pp. 9-57; Jacob A. Frenkel and Michael L. Mussa , "Efficiency of Foreign Exchange Markets and Measures of Turbulence", American Economic Review, vol. 70, no. 2 ( May 1980); and Frenkel, "Flexible Exchange Rates in the 1970"s, Stabilization Policy: Lessons from the 1970s and Implications for the 1980s (St. Louis: Center for the Study of American Business, Washington University, 1980).

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