The Theory Of Monetary Models Of Exchange Rates

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In 1983, Richard Messe and Kenneth Rogoff famously tested myriad empirical exchange rate models (Messe and Rogoff 1983). To this time, three competing models of exchange rates existed: a flexible-price monetary model, a sticky-price monetary model, and a sticky-price monetary model with the current account incorporated. The main finding of their paper was that a random walk explained data better than any fundamentals-based model. I argue that the demonstrative reasoning used by these models fails to accommodate the true nature of exchange rates and prices. Further, I propose an analytical narrative framework would best capture the complex and interconnected nature of exchange rates. In this short paper, I explore the failure of price…show more content…
Yet, this fundamental logic fails to explain data better than a random walk. To understand the failure of the monetary models for exchange rates, consider the international market for currencies not as given, but as a generative process that is a contemporaneous function of many other intermingled processes. Simply from the models above, the exchange rate is a function of the general relative price level between two countries. The aggregate price level, which is far from being clearly determined, is also not given; it is a function of each individual price. That is to say, the aggregate price level is also generative process of many factors. Individual prices are not simply given, they are discovered and rediscovered through time. Each price is a function of too many factors to list. Each of these factors is concurrently affected by the other factors. The intermingled web of cause and effect for a single price is astounding. Not only do these models compare given aggregate prices, but they compare price levels implicitly assuming ceteris paribus. However, just as ice cream in the summer is a different good than ice cream in the winter, the same physical composition of materials in one country may be a different good than in another country. Or, two items that provide the same service may differ in quality between the countries. These differences are aggregated away and it is assumed that prices
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