The Asset Market Theory of the Exchange Rate: A Comment

Abstract

It has recently been suggested that because of the importance of asset markets in exchange rate determination a flexible exchange rate will not insulate a small open economy from price fluctuations abroad.' At one level, this view is hard to disagree with; wealth effects of this sort (and, undoubtedly, other complications as well) will inevitably make the insulating effect incomplete. On the other hand, as I will show below, the strong form in which this new view is sometimes postulated tends to vastly overrate the influence of asset market factors in determining the exchange rate and, as a result, to seriously overestimate its failure as an insulating device. In its most extreme form, the asset view of exchange rate determinations consists of three equations:2