Abstract
One of the key questions confronting international investors concerns what moves exchange rates? In this chapter, we look at a variety of alternative exchange rate theories. Firstly, we look at purchasing power parity (PPP) theory which has been advocated as a satisfactory model of exchange rate determination in its own right. Having looked at PPP theory, we proceed to examine how well-suited this theory is to explaining actual exchange rate behaviour since the adoption of generalized floating in 1973. As we shall see, PPP theory does not provide an adequate explanation of some of the observed features of floating exchange rates. Some possible explanations for the failure of PPP to hold are then discussed.
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Further reading
Pilbeam, K.S. (2006) International Finance Palgrave Macmillan.
Rosenberg, M. (2003) Exchange Rate Determination: Models and Strategies for Exchange Rate Forecasting McGraw-Hill.
Sarno, L. and Taylor, M.P. (2002) The Economics of Exchange Rates Cambridge University Press.
Chapter 12: Theories of Exchange Rate Determination
Ardeni, P.G. and Lubian, D. (1991) ‘Is there Trend Reversion in Purchasing Power Parity’, European Economic Review, 35, 5, pp. 1035–55.
Bilson, J.F.O. (1978a) ‘Rational Expectations and the Exchange Rate’, in Frenkel, J.A. and H.G. Johnson, The Economics of Exchange Rates, AddisonWesley, Reading.
Bilson, J.F.O. (1978b) ‘The Monetary Approach to the Exchange Rate: Some Empirical Evidence’, IMF Staff Papers, 25, pp. 48–75.
Dornbusch, R. (1976a) ‘Expectations and Exchange Rate Dynamics’, Journal of Political Economy, 84, pp. 1161–76.
Dornbusch, R. (1976b) ‘The Theory of Flexible Exchange Rate Regimes and Macroeconomic Policy’, Scandanavian Journal of Economics, 84, pp. 255–75.
Frenkel, J.A. (1979) ‘On the Mark: A Theory of Floating Exchange Rates Based on Real Interest Rate Differentials’, American Economic Review 69, pp. 610–22.
Frenkel, J.A. (1981) ‘The Collapse of Purchasing Power Parities during the 1970’s’, European Economic Review, 16, pp. 145–65.
MacDonald, R. (1988) Floating Exchange Rates: Theories and Evidence, Unwin Hyman, London.
Officer, L. (1976). ‘The Purchasing Power Parity Theory of Exchange Rates: A Review Article’, IMF Staff Papers, 23, pp. 1–61.
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© 2005 Keith Pilbeam
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Pilbeam, K. (2005). Theories of Exchange Rate Determination. In: Finance and Financial Markets. Palgrave, London. https://doi.org/10.1007/978-1-349-26273-1_12
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DOI: https://doi.org/10.1007/978-1-349-26273-1_12
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