Theories of Exchange-Rate Determination

  • Graham Bird


The general theory of the balance of payments constructed in the previous chapter may, with little difficulty, be modified to become a general theory of exchange-rate determination. With flexible exchange rates, a position of equilibrium as represented by a point of intersection between IS and LM, which lies off the BP schedule will result in a change in the exchange rate. Where equilibrium occurs below BP, giving a payments deficit, the exchange rate will depreciate. Where it occurs above BP giving a payments surplus the exchange rate will appreciate.


Exchange Rate Interest Rate Current Account Money Supply Purchase Power Parity 
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Notes and References

  1. 1.
    This chapter concentrates on factors which influence the exchange rate, it does not examine alternative generalised exchange-rate regimes. Readers interested in the arguments for and against different exchange rate systems should consult a textbook in international financial economics.Google Scholar
  2. 2.
    In the former case the location of LM does not alter and the size of the increase in the interest rate depends on the slope of LM, which itself in large part depends on the interest elasticity of the demand for money, becoming steeper as the elasticity falls. In the latter case LM shifts to the right thus offsetting the impact of the rightward shift in IS, reflecting the increase in government spending, on the rate of interest.Google Scholar
  3. 3.
    More is said about this important theorem in a later section of this chapter.Google Scholar
  4. 4.
    PPP may still hold even if there is a significant non-traded goods sector, provided there is a fixed price relationship between traded and non-traded goods. This may exist if changes in the prices of traded goods are transmitted to non-traded goods through factor markets or through changes in the pattern of demand induced by relative price changes.Google Scholar
  5. A related problem is to identify which price index to use in testing the PPP theorem or in predicting exchange-rate movements on the basis of differences in inflation rates across countries. The consumer price index, for example, may be unsatisfactory precisely because it includes the prices of non-traded goods.Google Scholar
  6. 5.
    The question of the way in which expectations are formed is also relevant to, for example, the discussion of investment, inflation, and the demand for money.Google Scholar
  7. 6.
    As with other parts of this book readers are encouraged to experiment with the analysis for themselves. Here, for example, the basic thought processes which are run through in the text can be used to analyse a situation where LM is non-vertical.Google Scholar
  8. 7.
    There has been a great deal of debate in the literature concerning whether speculation stabilises or destabilises exchange rates. Much depends on the way in which speculators form their expectations. Where they have a fixed view of the long equilibrium rate, profit-making behaviour will tend to stabilise the exchange rate around this level. With ‘elastic’ expectations, however — where a movement in the rate is taken to suggest a further movement in the same direction — speculation will destabilise exchange rates, while speculators will still make a profit. If speculators possess rational expectations, possessing perfect foresight of the future, they will exploit every opportunity to make a profit and their profits will therefore be maximised. This is linked to the idea of ‘efficient markets’, where directly new information becomes available it will be fully incorporated into the spot rate thus eliminating unexploited opportunities for profit through speculation. Another aspect of efficient markets is that expectations affecting the future spot rate will be incorporated into the forward rate which then becomes the best predictor of the future spot rate.Google Scholar
  9. great measure of support for rational expectations and efficient markets in the context of the exchange rate. Unexploited profit opportunities do seem to exist. Speculation may sometimes be dominated by uncertainty and high risk premia, and by bandwagon effects. Furthermore, the forward rate does not appear to be an accurate predictor of the future spot rate, suggesting that things that occur after the forward contract is signed are not foreseen. There appears to be little bias in the errors made, with differences between forward rates and actual future spot rates averaging out to zero over time.Google Scholar
  10. 8.
    Where real disturbances are more significant than monetary ones PPP is unlikely to hold even in the long run. It is generally accepted that PPP provides an inadequate explanation of short-run variations in exchange rates, with these normally being much more volatile than aggregate price levels.Google Scholar

Copyright information

© Graham Bird 1987

Authors and Affiliations

  • Graham Bird
    • 1
  1. 1.University of SurreyUK

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