Abstract
This paper develops a model of exchange rate determination that extends the Dornbusch-Frankel model to allow for large and sustained changes in real exchange rates. Real exchange rate changes are related to movements in the current account, both through changes in expectations about the long-run equilibrium real exchange rate and through changes in the risk premium. The model is estimated empirically for the dollar's weighted average exchange rate over the flexible rate period of the 1970s. The results indicate that innovations to the current account have been a significant determinant of the exchange rate, predominantly through changes in expectations.
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