How Sensitive Is the Dollar to Economic Policy?

A common feature of all traditional exchange rate models is that the value of the currency is determined as a derived demand from the underlying assets. This is true of early models that emphasized the current account as a key determinant of exchange rate movements (see, for example, Meade, 1951), later models that placed the emphasis on the capital account, and even models that integrated the current account as a long-term constraint in an otherwise short-term determination within the capital account (see, for example, Mundell, 1960, 1963; Fleming, 1962; Dornbusch, 1976; Dornbusch and Fisher, 1980). In these models, economic policy (both fiscal and monetary) would influence the value of the currency by altering other macroeconomic variables, such as GDP and short-term (or long-term) interest rates, which affect the derived demand for foreign currency. Thus, in these models, economic policy has an indirect effect on the currency. But most empirical euro-dollar models are unstable in the sense that the influence of variables such as (short- or long-term) interest rate differentials change over time from statistically significant to statistically insignificant, and sometimes from positive to negative.