The Impact of News and Alternative Theories of Exchange Rate Determination

Abstract

OVER THE LAST DECADE TWO OF THE MORE IMPORTANT developments in the area of exchange rate determination are the construction of the asset market model and the recognition that is a key factor affecting exchange rates. The asset market model has evolved as an alternative to the traditional flow model of exchange rate determination. In contrast to the flow model, where the exchange rate is determined by the flow demand for and flow supply of foreign exchange, exchange rates adjust to allocate the total stock of foreign exchange in question in the asset market model. This model may be presented in one of two forms the monetary approach or the portfolio-balance approach. The former is summarized in the work of Bilson (1978a), Dornbusch (1976), Frenkel (1976), Johnson (1976), and Mussa (1976, 1979), while the latter stems from the efforts of Branson (1981), Branson, Halttunen, and Masson (1977), Dooley and Isard (1982), Kouri (1976), Kouri and de Macedo (1978), and Rodriguez (1980). While the logical consistency of these models has enhanced their popularity, empirical support has been limited. The importance of unanticipated shocks or in explaining exchange rate behavior has been suggested by Dornbusch (1980), Frenkel (1981), Isard (1983), and Mussa (1979). The basis for this suggestion is the efElcient markets approach that suggests securities prices in a capital market should reflect all available information. Therefore, the predominant cause of exchange rate movements is news that could