Orthodox Approaches to Exchange Rate Determination: A Survey

John T. Harvey

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Abstract

The single most important development in international economic relations since World War II has been the exponential growth of international capital flows. By any standard, such transactions are now, far and away, the most numerous of all those that take place across national boundaries. As a consequence, they are also the dominant force in determining the demand for foreign currency (Harvey, 1991, 1993a, 1993b; Krause, 1991; Schulmeister, 1987; Shelton, 1994, p. 88). Over the same period, neoclassical economists have expressed increasing frustration over their failure to explain exchange rate movements (Dornbusch, 1987; MacDonald and Taylor, 1992, 1989; Pentecost, 1993; Visser, 1989). Despite the fact that this is one of the most well-researched fields in the discipline, not a single model or theory has tested well. The results have been so dismal that mainstream economists readily admit their failure. It is the premise of this paper that these two developments, the growth of the international capital market and the inability of the orthodox school to explain exchange rates, are related. The former has led to a situation in which the market for foreign currency, like Keynes' stock market, has become dominated by speculative activities (Keynes, 1964, pp. 147-164; Harvey, 1993a, 1993b, 1991; Krause, 1991; Schulmeister, 1987). Because neoclassical models have been slow to take this development into account, relying instead on the notion that some set of fundamental factors determines rates, the empirical performance of their models has been extremely poor. The paper proceeds as follows: First, there is a brief description of the growth of capital flows in international transactions. Next, the two most

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1936The General Theory of Employment, Interest and Money.1936The General Theory of Employment, Interest and Money, by John Maynard Keynes 2003The Economics of Exchange Rates 1954Essays in Positive Economics 1996The Case for Flexible Exchange Rates 1992The use of technical analysis in the foreign exchange market 1964The General Theory of Employment, Interest, and Money [1936]1981Flexible Exchange Rates, Prices, and the Role of "News": Lessons from the 1970s

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