This paper, written as a chapter for a Handbook of International Economics, reviews developments in the theory of international monetary economics from the late 1960's through the early 1980's. Following a review of the operation of the monetary mechanism of balance of payments adjustment in the context of the Mundell-Fleming model, the paper reviews the more modern analysis of the dynamics of balance of payments adjustment under fixed exchange rates and of exchange rate determination under flexible exchange rates. Beginning with a simple exposition of the monetary mechanism, the model is then extended to incorporate sluggish wage and output adjustments, endogenous monetary policy and sterilization operations, multiplicity of tradable and nontradable goods, large countries, capital mobility and portfolio balance. The review then turns to an exposition of exchange rate theory, starting with the monetary approach to exchange rate determination. Issues discussed in this context include purchasing power parities, nontraded goods, the real exchange rate, currency substitution and the interaction between real and monetary factors in effecting exchange rates.The paper proceeds with a presentation of a more general framework that views the question of exchange rate determination as part of the general theory of the determination of asset prices, and which highlights the unique role of expectations. The general framework is then applied to characterize the interaction between the balance of payments and the equilibrium real exchange rate.The paper concludes with a brief discussion of some empirical issues of exchange rate analysis.

Asset markets, exchange rates and the balance of payments

Publisher Summary This chapter reviews developments in international monetary economics from the late 1960s through the early 1980s. It discusses that the “monetary approach to the balance of payments” was the economic determinants of the behavior of the balance of payments, especially, the theoretical elaboration and empirical investigation of the dynamic mechanism of balance of payments adjustment. Recent research on macroeconomics, for both closed and open economies, expresses far less confidence in the ability of governments to systematically affect levels of national income and consistently maintain full employment through policy manipulation. The chapter discusses that in earlier work on exchange rate theory, the condition for equilibrium in the flow market for foreign exchange transactions has been regarded as the proximate determinant of the exchange rate. In some analyses, expectations of future exchange rates had an important influence on current exchange rates by affecting speculative capital flows. The chapter also provides modern analysis of the dynamics of balance of payments adjustment under fixed exchange rates beginning with a simple exposition of the key elements of the monetary mechanism of balance of payments adjustment. Finally, the chapter also deals with the theory of flexible exchange rates. The evolution of the international monetary system from a regime of pegged exchange rates into a regime of flexible rates resulted in a renewed interest in the theory of exchange rate determination.

Chapter 14 Asset markets, exchange rates and the balance of payments

Fixed versus flexible exchange rates: A reservoir simile

Current views about flexible exchange rate systems are based, to a large extent, on the lessons from the period of the 1920's during which many exchange rates were flexible. This paper re-examines the evidence from the perspective of the recently revived monetary approach (or more generally, asset-market approach) to the exchange rate. The analysis starts by developing a simple monetary model of exchange rate determination. The key characteristic of the model lies in the notion that, being a relative price of two monies, the equilibrium exchange rate is attained when the existing stocks of the two monies are willingly held. The equilibrium exchange rate is shown to depend on both real and monetary factors which operate through their influence on the relative demands and supplies of monies. The analysis then proceeds to examine the relationship between spot and forward rates for the Franc/Pound, Dollar/Pound and Franc/Dollar exchange rates and the results are shown to be consistent with the efficient market hypothesis. The monetary model is then estimated using monthly data and using the forward premium on foreign exchange as a measure of expectations. In addition to the single-equation ordinary-least-squares estimates, the various exchange rates are also estimated as a system using the mixed-estimation procedure which combines the sample information with prior information which derives from the homogeneity postulate and from known properties of the demand for money. The various results are shown to be consistent with the predictions of the monetary model.

Exchange Rates in the 1920'S: A Monetary Approach

Inflation and dollar accounts in Peru's banking system, 1978–1984

I. The model, 97. — II. The equations of change: Free currency interflow and the "Rybczynski" effect, 99. — III. Comparative statics and comparative systems, 104. — IV. Concluding remarks, 107. — Appendix: The case of perfect mobility of capital, 109.

Diversified Currency Holdings and Flexible Exchange Rates

I. Customary dynamic analysis, 489. — II. Alternative dynamic system, 492.— III. Concluding remarks, 493.

Chau-nan Chen

Papers

Diversified Currency Holdings and Flexible Exchange Rates

Capital Mobility and the Stability of the Flexible Exchange Rate System