Efficient Foreign Exchange Markets and the Monetary Approach to Exchange-Rate Determination

Abstract

Recent contributions to the balance-ofpayments literature (see Robert Barro; Rudiger Dornbusch; Jacob Frenkel; Hans Genberg and Henry K. Kierzkowswki; Donald Kemp; Michael Mussa; Michael Parkin) have focused on the determination of the exchange rate viewed as a relative price of two national monies. We shall refer to this approach as the monetary approach. From this perspective, the exchange rate is seen as endogenously determined by stock equilibrium conditions in markets for national monies, and the major theoretical focus is the supply and demand functions for monetary stocks. The demand functions are typically specified to correspond to conventional macro-model money demand equations involving income, the rate of interest, and, perhaps most importantly, expectations concerning future exchange rates. Several of the specifications permit the simultaneous determination of the exchange rate and the expected future exchange rate by imposing restrictions which characterize rational expectation formation. Other models include broader specifications, and additional asset supply and demand equations. Despite their differences, a common theme runs through all these studies: While it is recognized that the exchange rate is not purely a monetary phenomenon (being affected in part by the real determinants of the demand for money), the thrust of the new asset approach to exchange rates is that the exchange rate is primarily determined by current and past innovations in the relative supplies of national monies. It is therefore not surprising that the few empirical efforts at testing this approach to exchangerate determination have estimated reducedform equations for the exchange rate as a distributed-lag function of the domestic money supply or the ratio of the domestic money supply to the foreign money supply.1 These empirical tests implicitly assume exogeneity of the money supply in order to assure consistency of dynamic regression estimates. At the same time that we are witnessing an elaboration of monetary theories of exchange-rate determination, there exists a parallel literature (see Michael Dooley and Jeffrey Shafer; William Poole; John Pippenger; John Geweke and Feige) which develops a theory of exchange-rate determination based on the hypothesis that foreign exchange markets are efficient markets. These writings are largely derivative from the extensive theoretical developments in the security market literature (see Eugene Fama). The efficient market hypothesis suggests that economic agents act upon information available to them in such a way that the spot exchange rate always reflects all available information that could be potentially useful in developing trading rules that earn excess profits. To date, tests of the efficient foreign exchange market hypothesis have been limited

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