A synthesis of the macroeconomic approaches to exchange rate determination

Abstract

The paper develops a general model with the goods, money, domestic and foreign bond, and labor markets. The special assumptions needed to generate the predictions of the different approaches from the model are found. It turns out that the assumption of perfect capital mobility essentially generates the monetarist predictions, and perfect monetary sterilization by the central bank at a fixed interest rate the predictions of the elasticity-absorption approach. The approaches turn out to be independent, rather than conflicting parts of the general model, each approach abstracting from what the other is analyzing. This is technically done by dichotomizing the general model, the monetarists making the money market equation, and the Keynesians the goods market and balance payments equations the independent ones. While the Keynesian, monetarist, and short-term portfolio balance approaches differ in their policy regime assumptions, the long-run portfolio balance approach differs in its equilibrium condition, by constraining the trade balance to equilibrium.