Recent Thinking About Exchange Rate Determination and Policy

There is a certain irony in the title of the paper that I was asked to write for this Conference. While there has, of course, been a lot of recent work on exchange rate determination, this work has had little impact even on sophisticated policy analysis. Indeed, it is striking that policy discussion has been based on an underlying model of exchange rate determination that has changed little since the mid-1970s. The workhorse model of policy analysis remains the Mundell-Fleming approach, modified mainly to allow for some expected regression of the exchange rate towards a long-run 'normal' level. Consider, for example, the way in which most commentators discuss the exit of the United Kingdom from the exchange rate mechanism of the European Monetary System (EMS). We say that the purpose of the exit was to allow the Bank of England to cut interest rates; that this cut in rates inevitably led to a fall in the pound sterling against the deutschemark (DM); and that the combination of more competitive UK exports and the investment effects of the lower interest rates have allowed the United Kingdom to begin an economic recovery even while the rest of Europe continues to slump. What is the underlying model? Clearly, it is IS-LM with high capital mobility plus regressive expectations on the exchange rate, right out of an undergraduate textbook (say, to take an arbitrary example, Krugman and Obstfeld (1991)). Why isn't there a more up-to-date canonical model of exchange rate determination? It is not for the want of trying. Indeed, there was a 'heroic age' of exchange rate theory from the mid-1970s to the early 1980s. During that era there were major competing schools of exchange rate theory (Dornbusch's overshooting model, the monetary models of Frenkel and Mussa, the portfolio models of Kouri and Branson) that attracted both efforts at theoretical extension and a considerable amount of empirical work. By about 1979, one would have described exchange rate economics as a field dominated by innovation, and one in which ideas were rapidly changing. Unfortunately, that heroic age ended when empirical work succeeded in refuting not one or two but all of the contending theoretical approaches. From my point of view, the two key papers were Hansen and Hodrick (1980) and Meese and Rogoff (1983). The Hansen and Hodrick paper was the first of what was to become a host of papers refuting the proposition …