Exchange Rates, Expectations and the Current Account

Abstract

In Chapter 1 we briefly looked into the relationship between the exchange rate and the current account required to maintain continuous balance in that account. This relationship is at the heart of exchange rate theories which build upon capital immobility since under capital immobility the role of the exchange rate is to preserve current account balance at all times. When capital is immobile internationally there is no asset role for the exchange rate to play; rather its role is to equate the (flow) demand for goods with the (flow) supply of goods and to balance absorption with income. The role of the exchange rate is to preserve flow equilibria. In Chapter 3 we looked, in some detail, into the relationship between the exchange rate and the current account in a world with perfect capital mobility, imperfect asset substitutability and continuous PPP. When capital is perfectly mobile internationally the exchange rate enters directly into the modelling of asset markets to equate the stock demand for assets denominated in different currencies with the stock supply of these assets and it continues with its role of bringing into equilibrium the flow demand for goods with the flow supply of goods. Given the existing supply of assets the role of the exchange rate is to preserve stock flow equilibria at any moment in time. However these momentary stock flow equilibria may not correspond with a balance between absorption and income and, as a result, current account imbalances may emerge.