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  • Print publication year: 2003
  • Online publication date: September 2012

4 - Exchange rate determination: theories and evidence

Summary

The very early Keynesian approach to exchange rate determination and exchange rate movements was developed initially by Lerner (1936), Metzler (1942a, 1942b), Harberger (1950), Laursen and Metzler (1950) and Alexander (1952). To a large extent, these studies focus on the importance of the elasticities of demand for and supply of exports and imports as well as the demand for and supply of foreign currency, and on the investigation of the conditions under which a devaluation may be effective in improving the balance of trade. In particular, the contributions to the elasticity approach by Marshall (1923), Lerner (1936) and Harberger (1950) are often celebrated for formalising the sufficient condition for a devaluation of the exchange rate to improve the balance of trade – that the sum of the demand elasticities of imports and exports be greater than unity in absolute value. During the 1950s and 1960s, the subsequent literature on open-economy macroeconomics was based on the underlying theory that the elasticities approach captures the short-run movements in the exchange rate, whereas the multiplier approach is the relevant exchange rate determination model in the medium term.

Notable work in the World War II and immediate post-war periods includes studies by Nurkse (1944) and Friedman (1953). The former warns against the dangers of ‘bandwagon effects’, thereby providing a case for fixed exchange rates. However, Friedman (1953) argues strongly in favour of floating exchange rates on the grounds that speculation may produce stabilising effects in the foreign exchange market.

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