Exchange Rate Economics: Theories and Evidence

200 Real exchange rate determination
viewed as a general equilibrium model of the exchange rate and we label it the
eclectic exchange rate model (EERM). It has a number of attractions. First,since
it incorporates aspects of the asset market approach,like the monetary models
discussed in the last chapter,it captures key features of exchange rate behaviour,
such as the current spot price being closely tied to the expected price. Second,
by incorporating concepts from the balance of payments equilibrium condition,
flow elements,such as those suggested in the portfolio balance approach to the
exchange rate,are introduced into the process of exchange rate determination. In
particular,the model recognises that changes in net foreign asset holdings and real
shocks generate changes in the balance of payments that may require real exchange
rate adjustment,even in equilibrium. This seems a particularly attractive feature of
the model since,as we noted in Chapter 2,PPP on its own does not seem sufficient
to explain the equilibrium behaviour of exchange rates. A further advantage of the
explicit modelling of a balance of payments sector,in combination with a monetary
sector,is that it introduces issues of sustainability in a natural way (a characteristic
emphasised in the fundamental equilibrium exchange rate (FEER) approach to
exchange rate modelling discussed in the next chapter).
A useful starting point for our discussion here is the definition of the real exchange
rate introduced previously as:
q = p − (s + p ∗ ),(8.1)
where p denotes the logarithm of the domestic price of domestic goods, p ∗ denotes
the logarithm of the foreign price of foreign goods and s the logarithm of the
domestic price of one unit of foreign exchange. When a variable is not explicitly
dated in this section it is assumed to be contemporaneous,that is,period t. The
logarithm of the general price level, P,in the home country is assumed to be a
weighted average of p and s + p ∗ :
P = σ p + (1 − σ)· (s + p ∗ ) = s + p ∗ + σ q,(8.2)
where σ denotes the weight of domestic goods in the domestic price index.
Expression (8.2) may be used to define the expected nominal exchange rate in
period n,as:
E t s n = E t P n − E t p ∗ n − σ E tq n . (8.3)
This decomposition of the expected nominal exchange rate illustrates three
key channels of exchange rate determination in this model; two of these, P and
p,are consistent with the exchange rate continually tracking PPP,whilst the
third is clearly not. We now consider each of these channels in a little more
detail.