New exchange rate economics contents 1 traditional. The theoretical part presents an intertemporal monetary model of a small open economy. The theory states that there is a link between the nominal interest rates in two countries and the exchange rate between their currencies. So the variance of the change of the asset price is dominated by the change of the random walk component as the dis count factor approaches one. Kennedy school of government harvard university cambridge, ma 028 revised, september 2008 abstract i provide evidence that undervaluation of the currency a high real exchange rate stimulates economic growth. Explaining theories of economic growth economics help.
Analysis of four main theories of interest rate are. Moreover, sustained real exchange rate overvaluation will, by distorting resource allocation away from productive activities, eventually lead to drastic adjustments of relative prices and reduction of aggregate economic growth. The bulky book deals with exchange rate theories on 225 pages, almost 30 % of the book. The views expressed in this working paper are those of the authors and do not necessarily. The real exchange rate and economic growth abstract i show that undervaluation of the currency a high real exchange rate stimulates economic growth. Exchange rates and the foreign exchange market ft chapter topics. Theories and evidence is the second edition of floating exchange rate.
It may even turn out that seemingly contradictory theories are each valid in that they apply in different circumstances, but we must still work out. Although several researchers have tried to explain the phenomenon of fdi, we cannot say there is a generally accepted theory, every new evidence adding some new elements and criticism to. Economic theory suggests passthrough will vary across countries and over time depending on an economys openness to imports goldberg and campa 2010, the distribution costs of bring ing goods to market burstein, neves and rebelo 2003, the source of exchange rate movements. The ppp theory suggests that the change in price level is the cause and the change in exchange rate is an effect. Its steadystate level is determined by the need to have a current account balance that will keep the debtgdp ratio constant, while. Shifts in demand, shown by shifts in u, lead to immediate off setting changes in the real exchange rate. In the short period, both capital flows and payments on the current account play a role. The real exchange rate and economic growth dani rodrik john f. Real exchange rate volatility and economic openness. It is fair to say that this evidence casts a great deal of doubt on the monetary. This book is a survey of exchange rate economics, which covers the main theories which explain the determination of exchange rates and uses recent empirical data on exchange rate behaviour using the latest econometric techniques. A theory of determination of the real exchange rate.
In the very short period, only capital flows are relevant. The ppp theory has a long history in economics, dating back several centuries, but. The conventional way of reporting this in economics is home currency per foreign. This regards the exchange rate as a forwardlooking asset price. This paper relates the volatility of the tradeweighted effective real exchange rate to the degree of trade openness of an economy. Department of energy washington, dc 20585 this paper is released to encourage discussion and critical comment. Exchange rate economics theories and evidence taylor. Assuming nonexistence of tariffs and other trade barriers. Review of exchange rate theories in four leading economics textbooks. Theories of exchange rate determination international.
This week jacob and adriene walk you through the basics of imports, exports, and exchange. Interest rate parity is one of the most important theories in international finance because it is probably the best way to explain how exchange rate values are determined and why they fluctuate as they do. Exchange rate theories and empirical evidence there are basically three views of the exchange rate. Theory and evidence prepared by adolfo barajas, ralph chami, dalia s. Project muse real exchange rate volatility and economic. In the long period, the capital account and the current account are individually in equilibrium. Theories of exchange rates foreign exchange financial.
From 2002 to 2012, the canadian exchange rate appreciated by 57%, which, according to our model, led to a 6. First, we test whether exchange rates are cointegrated with longrun determinants predicted by economic theory. Economic stagnation that characterized most of human history until the eighteenth century. The changes in prices induce the changes in exchange rates. Recent analyses, in contrast, have paid it more attention. Ppp and its variants in depth, real exchange rate determination, new open macroeconomics, economics of fixed exchange rates, the microstructure approach, and uip. I provide evidence that undervaluation a high real exchange rate stim%.
The theory repudiates that changes in exchange rates can cause changes in price level. Since market participants have incomplete information about the state of the economy, interest rate surprises carry potentially new information about the natural. The their analysis provided evidence that the shocks to terms of trade, nominal exchange rate, capital inflow and share of investment have persistent effects on the real exchange rate. Theory and evidence magda kandil international monetary fund this paper examines the effects of exchange rate fluctuations on real output growth and price inflation in a sample of twentytwo developing countries. Theories, evidence and policy, second edition provides basic introduction to various aspects of monetary economics. Sahoko kaji open economy macroeconomics lecture notes iii iii1 iii. The relationship between oil prices and exchange rates. Theories of exchange rate determination the different theories a theory of exchange rate determination explains how the exchange rate is determined. The first takes the exchange rate as the relative price of monies. This is true particularly for developing countries. Review of exchange rate theories in four leading economics.
It is also called the covered interest parity theory. The book, from one of the experts on the subject, nicely covers the key theories on exchange rate determination. The first chapter tackles the functions, advantages, and definitions of money. The exchange rate is the rate at which one currency trades against another on the foreign exchange market. We study the longrun relationship between nominal exchange rates and monetary fundamentals in a quarterly panel of 19 countries extending from 1973. Does trade openness influence the real effective exchange. X15 september 2001 with 3,244 reads how we measure reads.
The real exchange rate was not at the center of the first generation of neoclassical growth models, nor was it prominent among the policy prescriptions that flowed from those models. The poor explanatory power of these traditional models alongside with the empirical evidence. This article throws light upon the three theories of determination of foreign exchange rates. An overview of the b alassa s amuelson hypothesis in asia takatoshi ito, peter isard, and steven symansky 4. Using a dataset of 101 countries over the 19602011 period, we examine the relationship between the real effective exchange rate reer, on the one hand, and trade openness, trade balance, the terms of trade, factor productivity, and exchange rate. The model determines at a point in time the level of output and the exchange rate, as well as the rate of inflation and depreciation, as a function of prices. Well, it all has to do with imports and exports and, well, trade.
This pdf is a selection from an outofprint volume from the national. The theory applies to financial securities, and it makes the following assumptions. There is a signicant degree of evidence in the literature that capital. Exchange rate theory and the fundamentals article pdf available in journal of post keynesian economics 241. Exchange rate economics v abstract much of the paper is devoted to expounding the standard model of the exchange rate accepted by most economists today.
Further chapters on the history of the world monetary system, optimal currency areas and the european monetary union add to the theories. A fourperiod classification is used to categorise recent exchangerate theories or models. Exchange rate economics iii about the series the commission on growth and development led by nobel laureate mike spence was established in april 2006 as a response to two insights. Hakura, and peter montiel1 december 2010 this working paper should not be reported as representing the views of the imf. Theories and evidence this book is the second edition of floating exchange rates. Analysis of the main theories of interest rates todays debate on the interest rate is characterized by three key issues. Workers remittances and the equilibrium real exchange rate. By sticking closely to the evidence of the real world, we can eliminate theories that do not fit and narrowdown to those which best explain the evidence. We investigate the impact of movements in the real exchange rate on economic. This can be achieved by means of higher inflation andor higher real interest rates, depending on the degree of capital mobility. The debate over fixed versus flexible exchange rates is one of the longest running sagas in the international economics literature. Exchange rate appreciations lower the cost of imported goods, but also lead to more crossborder shopping. The their analysis provided evidence that the shocks to terms of trade, nominal exchange rate, capital inflow and share of investment have persistent effects on the real exchange rate in the short.