The Exchange Rate, the Balance of Payments and Monetary and Fiscal Policy under a Regime of Controlled Floating

TLDR

The exchange rate is the relative price of national monies, determined by money supply and demand, expectations of future rates, and real factors. The study investigates extending the monetary approach to balance‑of‑payments analysis to a controlled floating regime with active intervention. The authors develop this extension by incorporating rational‑expectations implications and analyzing the effects of intervention on exchange‑rate dynamics. They find that exchange rates are set by money supply, expectations, and real factors, and that controlled floating reduces but does not eliminate policy‑conflict problems.

Abstract

Abstract This paper considers the extension of the fundamental principles of the monetary approach to balance of payments analysis to a regime of floating exchange rates, with active intervention by the authorities to control rate movements. It makes four main points. First, the exchange rate is the relative price of different national monies, rather than national outputs, and is determined primarily by the demands and supplies of stocks of different national monies. Second, exchange rates are strongly influenced by asset holder’s expectations of future exchange rates and these expectations are influenced by beliefs concerning the future course of monetary policy. Third, “real” factors, as well as monetary factors, are important in determining the behavior of exchange rates. Fourth, the problems of policy conflict which exist under a system of fixed rates are reduced, but not eliminated, under a regime of controlled floating. A brief appendix develops some of the implications of “rational expectations” for the theory of exchange rates.