Faus en, Die ich K.
A icle
The Role o Exchange Ra es. A Reconcilia ion o Al e na i e
App oaches
K edi und Kapi al
P o ided in Coope a ion wi h:
Duncke & Humblo , Be lin
Sugges ed Ci a ion: Faus en, Die ich K. (1982) : The Role o Exchange Ra es. A Reconcilia ion o
Al e na i e App oaches, K edi und Kapi al, ISSN 0023-4591, Duncke & Humblo , Be lin, Vol. 15, Iss.
4, pp. 556-565,
h ps://doi.o g/10.3790/ccm.15.4.556
This Ve sion is a ailable a :
h ps://hdl.handle.ne /10419/292942
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The Role o Exchange Ra es
A Reconcilia ion o Al e na i e App oaches
By Die ich K. Faus en, Clay on*
The exchange a e cons i u es a ela i e p ice. Howe e , he na u e
o his p ice ela ionship has o la e become su ounded by con o e sy.
One iew holds ha he exchange a e is he ela i e p ice o na ional
ou pu s. This "con en ional" iew is gene ally associa ed wi h he
pu chasing-powe -pa i y doc ine (PPP) as well as wi h he pa ial
equilib ium (income-expendi u e and elas ici ies) app oaches o he
balance o paymen s and he exchange a e, espec i ely. The al e -
na i e, "mone a y", iew main ains ha he exchange a e is he
ela i e p ice o na ional monies, s ic ly a mone a y phenomenon, and
i is associa ed wi h he ecen ly de eloping mone a y o asse app oach
o he exchange a e. P oponen s o he mone a y iew equen ly de-
cla e he adi ional iew as "e oneous" o " allacious". Thus he
imp ession is being gene a ed, and s a ed explici ly on occasion, ha
he adi ional and mone a y iews cons i u e wo mu ually exclusi e
concep ions o he ole and de e minan s o exchange a es. I is my
con en ion ha his is a spu ious con adis inc ion, ha nei he he
adi ional no he mone a y iew is in insically allacious bu ha
hey cons i u e complemen a y app oaches o and concep ions o ex-
change a es whose espec i e impo ance is o some ex en dependen
o he ime dimension o analysis. This is no o deny ha ei he
app oach can be, and has been, e oneously applied yielding misleading
esul s and policy ecommenda ions. This is p ecisely he case whe e
he analysis is exclusi ely p eoccupied wi h nai e e sions o ei he
app oach. On he o he hand, he p ope ies o long- un s a iona y
gene al equilib ium clea ly iden i y he exchange a e as he ela i e
p ice o na ional ou pu s while he cha ac e is ics o dynamic adjus -
* I g a e ully acknowledge help ul commen s om and discussions wi h
Max Co den, Thomas Maye and Hans Molle , and inancial suppo om
he Alexande on Humbold -Founda ion.
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The Role o Exchange Ra es 557
men beha iou sugges he impo ance o asse ma ke conside a ions
in he sho - un de e mina ion o exchange a es.
I. De e minan s o he Exchange Ra e
The exchange a e mus clea he ma ke o o eign exchange. The
obse a ion ha i cons i u es he ela i e p ice o na ional monies is
au ologically ue and, he e o e, does no quali y as he di e en ia -
ing c i e ion be ween he al e na i e app oaches. Such a c i e ion
mus be sough in he pa icula beha io al concep ion o he cons i-
uen elemen s o he o eign exchange ma ke . This issue is succinc ly
epi omized in he alid con on a ion o low and s ock app oaches.
1. Flow App oach
The balance o paymen s and i s a ious componen s a e iewed as
equilib ium low phenomena. Demand o and supply o o eign ex-
change a e de i ed om he ele an balance o paymen s lows. I is
a cha ac e is ic and a po en ial weakness o he con en ional app oach
ha i gene ally ocuses only on cu en accoun ansac ions as
de e minan s o he o eign exchange ma ke , conside ing balance o
paymen s adjus men as a special p oblem o gene al p ice heo y.
In his basic model he demand o o eign exchange is de i ed om
domes ic demand o impo s and he supply o o eign exchange om
o eign demand o domes ic expo ables. Consequen ly, he exchange
a e is de e mined by he de e minan s o he low demands o and
supplies o adeables — p incipally ela i e commodi y p ices and
incomes. These a iables also cons i u e he majo ehicles o he
ansmission mechanism which p esupposes e icien commodi y a bi-
age. Ano he impo an de e mining a iable is he s a e o expec-
a ions which is usually ecognized in he con ex o "leads and lags" in
o eign exchange paymen s, bu which can also exe di ec in luence on
he ansac ions in adeables hemsel es. The equilib ium exchange
a e is ha which balances he equilib ium lows o impo s and ex-
po s, and i is in his sense de e mined in he commodi y ma ke
and ega ded as he ela i e p ice o na ional ou pu s.
The p eoccupa ion wi h he cu en accoun implies he i ual
neglec o capi al mo emen s in he de e mina ion o exchange a es
(S ii zel, 1958, Ch. 4.5). This neglec is explicable on he one hand in
e ms o basic balance o paymen s accoun ing p inciples which ensu e
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558 Die ich
K.
Faus en
ha he cu en accoun balance is equal o he nega i e capi al
accoun balance including ese e mo emen s. On he o he hand, i
was a classical con en ion ha sho - e m capi al mo emen s a e
in insically accommoda ing and, he e o e, ansi o y, and ha long-
e m capi al mo emen s, de e mined by he eal yield s uc u e, will
p ecipi a e he equisi e adjus men s o he cu en accoun balance
h ough ela i e p ice and income e ec s. In hose ins ances whe e he
basic model is ex ended o inco po a e capi al mo emen s, i s essen ial
low na u e emains una ec ed: capi al mo emen s, like commodi y
ansac ions, a e concei ed o as equilib ium low phenomena. The
olume o capi al lows is de e mined by in e na ional yield di e en-
ials, and he low demands o and supplies o o eign exchange a e co -
espondingly augmen ed. The exchange a e con inues o be de e mined
in he low o in e na ional unds ma ke and, gi en e icien com-
modi y a bi age, con inues o ep esen he ela i e p ice o na ional
ou pu s.
2. S ock App oach
The basic heo e ical p esump ion o his app oach is he pos ula e
o pe asi e po olio balance beha io . Consequen ly, asse ma ke s
occupy he cen e o analysis. Demands and supplies e e o he
s ocks o he a ious asse s and a e de e mined acco dingly. Po olio
imbalance gi es ise o lows which a e s ic ly disequilib ium adjus -
men phenomena, in insically ansi o y in a s a iona y en i onmen ,
and hey play no pa in he de e mina ion o equilib ium asse p ices.
Tha p ice is de e mined ins ead by he in e ac ion o he s ock demand
o and supply o he espec i e asse . The impo an de e mining
a iables o he s ock demands o asse s a e eal income and weal h,
p ice le els and a es o e u n, and expec a ions.
Applied o he exchange a e as he ela i e p ice o asse s de-
nomina ed in di e en cu encies, his app oach main ains ha he
equilib ium exchange a e is de e mined in asse ma ke s. As in he
con en ional app oach, he exchange a e clea s he ma ke o in e -
na ional lows o unds. These lows, howe e , a e no longe de i ed
om equilib ium commodi y (and capi al) lows, bu om s ock dis-
equilib ium in he a ious asse ma ke s und a e de e mined acco d-
ingly. In he s ock app oach he in e na ional exchange o goods and
se ices is i ually excluded om analysis, and he impo ance o
commodi y a bi age is dep eca ed
(F e ikel,
1976, p. 204).
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The Role o Exchange Ra es 559
One la en weakness o his app oach in he con ex o pe iod
analysis is ha s ock and low equilib ium condi ions a e no neces-
sa ily equi alen . Fo mally i can be shown ha equi alence holds in
con inuous ime analysis (Foley, 1975, p. 319) bu ha in pe iod analysis
s ock equilib ium implies low equilib ium only i he addi ional as-
sump ion o pe ec o esigh is made (idem, p. 317). This p oblem,
howe e , becomes less signi ican he highe a e adjus men speeds
and he lowe a e adjus men cos s o po olio imbalance.
II. The Mone a y App oach
The mone a y app oach o exchange a es in i s ex an e sions
(e.g. he con ibu ions in he Scandina ian Jou nal o Economics, 1976,
No. 2 and in F enkel and Johnson, eds., 1978) is a subse o he s ock
app oach. I is a subse o he s ock app oach because — designa ions
o "asse app oach" and e e ences (usually in pa en heses o oo no es)
o he gene ic concep o „asse s" no wi hs anding — i ocuses mainly
on one single asse , namely money. "As usually o mula ed, he mone a y
app oach s esses ha he exchange a e, as he ela i e p ice o wo
monies, is de e mined by he equilib ium be ween he demands o
and he supplies o he s ocks o money ou s anding" (Hod ick, 1978,
p. 97). The usual assump ion in ha li e a u e is ha unde lexible
exchange a es nominal money supplies a e exogenously de e mined.
As a consequence, he de e minan s o he s ock demand o money
assume s a egic impo ance o he de e mina ion o he equilib ium
exchange a e.
The simples s uc u e o his so o model is o de e mine mone a y
s ock equilib ium, domes ic and o eign; o in oduce his in o he PPP
ela ion which is explici ly di o ced om commodi y a bi age; o no e
ha he economy unde conside a ion is small so ha he o eign
p ice o he single commodi y is gi en and adjus men has o occu in
he domes ic money demand de e mining a iable(-s); and o conclude
ha he exchange a e is indeed he ela i e p ice o na ional monies,
de e mined in he money ma ke . (Inciden ally, ha asse ion could
be co obo a ed di ec ly, and wi hou signi ican loss o in o ma ional
con en , by no ing ha he p ice o money is he in e se o he p ice
le el and exp essing he PPP condi ion as he a io o hese quo ien s).
The exchange a e so de e mined is usually o minimal signi icance o
he ope a ion o he model excep pe haps o he speci ica ion o some
expec a ions mechanism wi h an exogenous elas ici y pa ame e .
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560 Die ich
K.
Faus en
In he speci ica ion o he demand o money unc ions "eclec icism"
appea s o p edomina e in hese models and i gi es ise o a peculia
admix u e o sho - and long- un conside a ions. The mone a y analysis
is essen ially o ien ed owa d he elucida ion o he p ope ies o long-
un s a iona y (o s able) equilib ium. This s a emen applies mos
os ensibly o he mone a y app oach o he balance o paymen s unde
ixed exchange a es, bu no less o i s "dual", he mone a y app oach
o he exchange a e. Tha long- un ime ho izon is app op ia e o as-
suming ha pe ec wage and p ice lexibili y secu e and main ain
he ull employmen le el o eal ou pu . On he o he hand, he
p ominen emphasis on asse conside a ions, based on he p esump ion
o ela i ely high adjus men speeds in asse ma ke s, is pa icula ly
apposi e in sho - un analysis "since wha go e ns in he sho un
he equilib ium p ice o money is he s ock demand and he s ock
supply" (Do nbusch, 1976 a, p. 276). Ye he assump ion o con inuous
ull employmen main enance is unc i ically e ained in his con ex
and, as a consequence, he eal income a iable is elimina ed om he
demand o money unc ion. Fu he , i espec i e o speci ica ion, he
demand o money is assumed o be a s able unc ion o a small numbe
o a iables — a long- un p oposi ion. Tha assump ion is also un-
c i ically e ained in he sho - un analysis e en hough he e is no
e idence o subs an ia e i s e aci y no does i possess a p io i plau-
sibili y (Pa kin, 1976, p. 253).
In he speci ica ion o he demand o money unc ion one can ob-
se e a a ie y o al e na i e hypo heses whose choice is no always
es imony o he disin e es edness o he esea che . Fo example, in
some models wi h money and equi ies he demand o eal balances is
pos ula ed o be an in e es -dependen unc ion o eal weal h (Do n-
busch, 1976 a; Myh man, 1976). In pu e mone a y models he expec ed
a e o in la ion has been iden i ied as he dominan de e mining
a iable o he demand o eal balances (F enkel, 1976) o , al e -
na i ely, he exchange a e, cu en le el and expec ed a e o change,
is ec ui ed as he s a egic de e minan o he demand o nominal
balances (Mussa, 1976). These money demand unc ions usually also
include he conspicuous "po man eau" a iable. The dis inguishing
cha ac e is ic o his so o model is an exceedingly selec i e applica-
ion o he s anda d con empo a y mone a y- heo e ic amewo k o
analysis. And his selec i i y is he mani es a ion o he lack o a
easonable comp ehensi e asse o po olio balance model. In such
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The Role o Exchange Ra es 561
a model money demand and, hus, he exchange a e would no longe
be he p o enance o a single as u ely chosen a iable bu a he o he
in e ac ion be ween asse , commodi y and labo ma ke s. The di o ce
o he exchange a e om ou pu conside a ions could no be sus ained
in a co ec ly speci ied model.
The pu chasing powe pa i y ela ionship has been iden i ied as he
"ideological an eceden " o he mone a y app oach o he exchange
a e (Hod ick, 1978, p. 97). Indeed, F enkel (1976, p. 203) a gues ha
"[ ]he o iginal o mula ion o Cassel was s a ed in e ms o he ela i e
quan i ies o money", ha " he ole o p ices in Cassel's compu a ion
o he equilib ium exchange a e se es only o p oxy he unde lying
mone a y condi ions. The de e mina ion o exchange a es does no
seem o ely, di ec ly o indi ec ly, on he ope a ion o a bi age in
goods" (emphasis added). This conjec u e is designed o bu ess he
e aci y o he claim ha he exchange a e is a mone a y phenomenon,
and i iden i ies he PPP ela ionship as a pa icula ly a ac i e "build-
ing block" o mone a y models. Bu i is a a iance wi h he ex ual
e idence. "I is no easy o see how Cassel could be in e p e ed his
way... The e could be li le doub ha wha de e mines he exchange
a e, in his p esen a ion [ci ed by F enkel], a e p ices o goods, which
a e he basic ac o in he model a he han a 'p oxy* o money...
The 'p oxy ela ionship' be ween p ices and money is hus, in Cassel's
wo k, he p ecise opposi e o ha which is a ibu ed o him by F enkel"
Michaely, 1978, pp. 33 - 4). The impo ance o ou pu ma ke s and
commodi y lows as one se o ac o s de e mining he equilib ium
exchange a e is a basic con en ion o he PPP doc ine. Bu his is no
an exclusi e emphasis. Dis u bances o igina ing in he mone a y
sec o can in luence he exchange a e as well. The ex en o which
he exchange a e is a "mone a y phenomenon" depends c ucially on
he ela i e s abili y o he wo sec o s. Wi hin he pu iew o he
PPP doc ine his is an empi ical and no an ap io is ic issue.
III. Reconcilia ion
The asse ion ha he exchange a e is an exclusi ely mone a y phen-
omenon has no ben es ablished by he p ac ione s o he mone a y ap-
p oach. A emp s o " es " he mone a y app oach and o co obo a e his
asse ion ha e e aded he p oblem p e iously iden i ied by B anson
and Hill (1971, p. 10) in a pa allel con ex : "we mus ely ai ly hea ily
on ou a p io i heo e ical speci ica ion o he model s emming om
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562 Die ich K. Faus en
he s ock-adjus men iew, and ob ain pa ame e es ima es mo e o
less condi ional on ha heo e ical iew being co ec , as opposed o
es ing he heo y agains he da a." This de iciency is pa icula ly
no iceable in he cha ac e is ic speci ica ion o he money ma ke whe e
he sho - un s abili y o he demand o money is aken o g an ed
and he money supply is conside ed exogenous. In he sho un, he
demand o money may be subjec o ansi o y shi s (Pa kin, 1976,
p. 253), while he exogenei y o he money supply is an exceedingly
unhelp ul assump ion (Co den, 1976, pp. 387 and 403). Fu he , con-
side ing he demand o money as a single unc ional ela ionship o
one o ano he "dominan " a iable may be expedi ious and plausible
unde speci ic his o ical ci cums ances — such as F enkel's (1976) in-
es iga ion o he Ge man hype in la ion — bu i is c ucially in-
adequa e as he heo e ical ounda ion o gene al ap io is ic s a e-
men s abou he ole and de e minan s o he exchange a e.
I should be no ed ha no all applica ions o he asse app oach a e
con ined o he na ow amewo k o he basic mone a y app oach
delinea ed abo e and, indeed, ha ecen esea ch appea s o be in-
c easingly o ien ed owa d b idging he e s while concep ual pola iza-
ion be ween mone a y and eal app oaches (e.g. Do nbusch and
Fische , 1980). Mussa (1976) de o es conside able e o owa d elucida -
ing some o he " eal causes and e ec s" o exchange a e beha io .
His discussion ge s aw ully muddled, howe e , in he a emp o e-
concile and in eg a e hese conside a ions wi h he unde lying mone-
a y pe spec i e. Empha ic insis ence ha eal ac o s in luence he
exchange a e only h ough hei "impac on he demand o money"
does no make he exchange a e " undamen ally an asse p ice" (p. 241).
In a pape dis inguished by i s comp ehensi e pe spec i e which eluci-
da es he join in luence o mone a y and eal a iables on he exchange
a e, Do nbusch (1976 b) asse s ha "o ganizing hough abou [ he
long- un de e mina ion o ] exchange a es a ound he mone a y
sec o is likely o be a di ec and in o ma i e app oach" (p. 260). Tha
poin emains o be es ablished and is con ingen upon an assump ion
ha is a ely spelled ou in de ail and is s ill he subjec o deba e.
The legi ima ion o concen a ing p incipally on money and c edi
ma ke s in mac oeconomic analysis de i es om one o he unda-
men al pos ula es o mone a ism, namely he p esump ion o he in-
he en s abili y o he p i a e sec o (B unne , 1970). Subjec o his
p o iso asse ma ke s, and mone a y policy in pa icula , assume s a-
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The Role o Exchange Ra es 563
egic impo ance o he de e mina ion o mac oeconomic equilib ium
in gene al, and he exchange a e in pa icula . I , on he o he hand,
he p i a e sec o is subjec o e a ic shocks and s uc u al changes
a ec ing consump ion and p oduc ion pa e ns, hen hese ac o s
dese e p ominen emphasis, e en wi hin he con ex o a s ock
app oach. This poin is ecognized in Myh man's "mone a y impulse
heo y" (1976, p. 186). Howe e , con a y o Myh man's asse ion, such
a heo y would need o dis inguish be ween he easons o changes in
he money supply. The e is a di e ence be ween mone a y policy
passi ely accommoda ing budge imbalances o ac i ely coope a ing in
he pu sui o s abiliza ion o dis ibu ion goals. Thus, a ela ionship
e-eme ges be ween he exchange a e and ou pu conside a ions.
The asse app oach o exchange a es has been help ul in o ien ing
analysis away om an exclusi e p eoccupa ion wi h low phenomena.
The emphasis on po olio balance clea ly iden i ies in e na ional asse
lows as ansi o y adjus men phenomena and unde lines he im-
po ance o expec a ions o exchange a e de e mina ion. I yields
use ul explana ions o his o ical episodes cha ac e ized by highly
ola ile exchange a e beha io . The alidi y o he app oach i sel is
independen o speci ic ins i u ional ac o s such as he eedom o
capi al mo emen s. E en in he p esence o pe asi e capi al con ols
his app oach is se iceable in explaining he beha iou o asse holde s
and i s e ec on he exchange a e and he balance o paymen s,
espec i ely. Howe e , his in a iance wi h espec o his o ico-ins i-
u ional ci cums ances does no apply o he .uses o which he app oach
has been pu . The e a e ample incidences in economic his o y (up o
he p esen ) whe e he p esump ion o mone a y ins abili y is app o-
p ia e and whe e mone a y dis u bances ha e exe ed he p edominan
in luence on exchange a es. Bu his obse a ion, and he "e idence"
ex ac ed om such episodes, is no su icien o designa e he exchange
a e a mone a y phenomenon and, con e sely, o denig a e as a "con-
cep ual e o " (Mussa, 1976, p. 233) he con en ional iew which
associa es he exchange a e wi h ela i e na ional commodi y p ice
le els. This claim is simply unsus ainable as a gene al p oposi ion and
i econcilable wi h he asse app oach i sel . On he one hand, he
dis ibu ion o asse s is go e ned by hei a es o e u n, by p ices,
ha is, which ca y a ime dimension and no by simple pu chase
p ices. The e o e, he p ice o na ional monies which is ele an in he
con ex o balance o paymen s analysis and adjus men is no he
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