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The Dynamic Interaction of Exchange Rates and Trade Flows

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  • William H. Branson
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    Abstract

    During the fifteen years since 1970, the theory of exchange-rate determination has been completely transformed. In the late 1960s, the standard model of the foreign exchange market had supply and demand as stable functions of exports and imports, with the expection that a floating rate would move gradually with relative price changes. However,the period of floating rates that began in the early 1970s has revealed that exchange rates exhibit the volatility of financial market prices.This experience, coupled with development of theory, led first to the"monetary" approach to exchange rate determination and then to the "asset market" approach. The monetary approach to exchange rate determination had essentially one-way causation from money to exchange rates, sometimes via purchasing power parity. The broader asset market approach assumes two-way causation.The exchange rate, in the asset-market view, is proximately determined by financial-market equilibrium conditions. It, in turn, influences the trade balance and the current account. The latter, in its turn, is the rate of accumulation of national claims on foreigners, and this feeds back into financial market equilibrium. Thus the asset market approach contains a dynamic feedback mechanism in foreign assets and exchange rates. This approach is called here a "fundamentals" model of exchange rate dynamics. Recent work on rational expectations adds a layer of expectations to the model. It is assumed that following an unexpected disturbance the market can anticipate where the fundamentals will move the system, and move the exchange rate in anticipation of that fundamentals path. This paper integrates the traditional elasticities and absorption approaches into the general equilibrium fundamentals model, and then add the expectations layer. The model is used to interpret recent shifts in U.S. fiscal policy and portfolio preferences for the dollar.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1780.

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    Date of creation: Dec 1985
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    Publication status: published as Peeters, Theo, Peter Praet, and Paul Reding (eds.) International Trade and Exchange Rates in the Late Eighties. Amsterdam and Oxford: North-Holland; distributed in the U.S. and Canada by Elsevier Science, N.Y, 1985.
    Handle: RePEc:nbr:nberwo:1780

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    References

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    1. P. Krugman & L. Taylor, 1976. "Contractionary Effects of Devaluations," Working papers 191, Massachusetts Institute of Technology (MIT), Department of Economics.
    2. William H. Branson, 1984. "Exchange Rate Policy after a Decade of "Floating"," NBER Chapters, in: Exchange Rate Theory and Practice, pages 79-118 National Bureau of Economic Research, Inc.
    3. Henderson, Dale W. & Rogoff, Kenneth, 1982. "Negative net foreign asset positions and stability in a world portfolio balance model," Journal of International Economics, Elsevier, vol. 13(1-2), pages 85-104, August.
    4. Branson, William H. & Katseli-Papaefstratiou, Louka T., 1980. "Income instability, terms of trade, and the choice of exchange rate regime," Journal of Development Economics, Elsevier, vol. 7(1), pages 49-69, February.
    5. Mussa, Michael, 1976. " The Exchange Rate, the Balance of Payments and Monetary and Fiscal Policy under a Regime of Controlled Floating," Scandinavian Journal of Economics, Wiley Blackwell, vol. 78(2), pages 229-48.
    6. William L. Branson, 1972. "The Trade Effects of the 1971 Currency Realignments," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 3(1), pages 15-70.
    7. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
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    Cited by:
    1. Malte Kr├╝ger, 1998. "Exchange Rate Effects of Portfolio Shifts?," UWO Department of Economics Working Papers 9818, University of Western Ontario, Department of Economics.
    2. Klundert, T.C.M.J. van de, 1989. "Reducing external debt in a world with imperfect asset and imperfect commodity substitution," Discussion Paper 1989-27, Tilburg University, Center for Economic Research.
    3. Klundert, T.C.M.J. van de, 1991. "Reducing external debt in a world with imperfect asset and imperfect commodity substitution," Open Access publications from Tilburg University urn:nbn:nl:ui:12-5146601, Tilburg University.
    4. William H. Branson & Jorge Braga de Macedo, 1987. "Smuggler's Blues at the Central Bank: Lessons from Sudan," NBER Working Papers 2220, National Bureau of Economic Research, Inc.

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