Abstract

Exchange Rate Theories and Economic Policy

The false trend of the dollar exchange rate in the years 1984 and 1985 has demonstrated very clearly to economic policy makers – especially those in the United States – that even in a system of flexible exchange rates they cannot adopt a completely passive attitude to exchange rate movements. The present study examines the extent to which the current monetary theories can serve as pointers for economic policy action aimed at reducing or avoiding misalignment of exchange rates. It proves that none of the prevailing theories have sufficient empirical relevance to enable derivation of operational action guidelines for monetary and economic policy. If less exacting demands are made on the theories, the financial market approach to exchange rates proves at least an orientation aid for economic policy, because it permits clearer recognition of the central factors for exchange rate determination than all other models. Nevertheless, at present monetary policy lacks a solid theoretical foundation. If it sets out to counter the misalignment of a currency (i.e. exchange rate trend no longer explainable on a medium-term basis with fundamental factors – as opposed to short-term deviations of an exchange rate from a specific trend of any sort), above all measures with a signal or announcement effect are recommendable, with which a correction of misguided exchange rate expectations is most likely to be effected. Target zones in the sense of non-binding declarations of intent by central banks are inadvisable, since this might risk the credibility of the central banks.