These models have been tested under both flexible-price and sticky-price assumptions and now offer a more refined, portfolio-balance approach. The chapter then moves to an analysis of models of exchange rate dynamics during the transition to flexible regimes and reviews the models that have adopted the modern asset markets approach to determining exchange rates during the transition. It then briefly reviews early models of the current account and the pricing-asset equilibrium models of the balance of payments under fixed exchange rates, which became the basis for modeling the behavior of flexible exchange rates after the collapse of the Bretton Woods system. The chapter begins with a discussion of the fundamental hypotheses underlying the models-PPP and interest rate parity-and comments on the models’ empirical validity. This chapter examines the econometric literature on models used to determine exchange rates and provides an in-depth analysis of their empirical validity. In turn, demand and supply depend on expectations, incomes, rates of return, and other factors that are relevant for portfolio choices. In modern models of exchange rate determination, the exchange rate, being the relative price of two national monies, is determined primarily by the relative supply of and demand for these monies. The asset market approach placed special emphasis on the role of expectations in exchange rate determination, and proponents explored different formulations of these expectations. This approach viewed the exchange rate as moving to equilibrate the international demand for stocks of money, rather than the international demand for flows of goods, as under the more traditional approach. The asset market approach, originally developed for fixed exchange rates, was soon adapted to the new reality of generalized floating. The advent of flexible (or managed) exchange rates in the early 1970s, coupled with greater capital mobility, increased the volatility of exchange rates and stimulated renewed interest in their economics, leading to new developments in the theory and empirical testing of exchange rate models. With the Keynesian revolution and the rapid expansion of international capital transactions related to international trade, however, the behavioral links between the balance of payments and the exchange rate were reexamined and embedded in models that took into account the interplay of external and internal pressures on exchange rates.
The recognition that exchange rates adjust to international payments established a relationship between the exchange rate and the balance of payments. The relationship between the interest rate and the exchange rate-known as the interest rate parity hypothesis-was bolstered as forward exchange markets developed. Policymakers were also aware that the behavior of exchange rates could be influenced by adjustments in interest rates: when interest rates rise, the exchange rate-the price of foreign currency in terms of domestic currency-falls, indicating an appreciation, or strengthening, of the domestic currency. Although the perception that exchange rates are related to national price levels had existed for a long time, it was with Cassel’s introduction of the term purchasing power parity (PPP) in 1918 that exchange rates became closely associated with the comparative purchasing powers of national currencies. Traditional models of exchange rate determination have focused on three types of explanatory variables: national price levels, interest rates, and the balance of payments.
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