JOURNAL OF INTERNATIONAL MONEY AND FINANCE (1982).

1,39-56
0 1902Buttcrworths

Fluctuations in the Dollar:

A Model of Nominal and Real
Exchange Rate Determination

PETER HOOPER* AND JOHN MORTON*

Board ofGovernors of the Federal Reserve System, USA

This paper develops a model of exchange rate determination that extends the
Dombusch-Frankel model to allow for large and sustained changes in real
exchange rates. Real exchange rate changes are related to movements in the
current account, both through changes in expectations about the long-run
equilibrium real exchange rate and through changes in the risk premium.
The model is estimated empirically for the dollar’s weighted average
exchange rate over the flexible rate period of the 1970s. The results indicate
that innovations to the current account have been a significant determinant
of the exchange rate, predominantly through changes in expectations.

Introduction
This paper develops and estimates empirically a model to explain movements in the
dollar’s foreign exchange value during the flexible exchange rate period of the
1970s. The design of the model has been influenced significantly by the large
fluctuations in real exchange rates observed during that period. The empirical
application is to the dollar’s weighted average exchange rate against the currencies
of ten major industrial countries.
The underlying theory, outlined in Section I, draws from both the monetary and
portfolio balance approaches to exchange rate determination. We begin with the
sticky-price monetary model developed by Dornbusch (1976) and extended by
Frankel (1979b) to allow for sustained inffation differentials across countries. The
Dornbusch-Frankel model is modified to allow for shifts in the long-run
equilibrium real exchange rate and the existence of exchange risk premia.
Shifts in the equilibrium real exchange rate are related to movements in the
current account through an expectations mechanism that is consistent with

* We have benefited from discussions with Michael P. Dooley, Jdfrey A. Frankel. Peter Isard,
JcfIrcy R. Shafer and Ralph W. Smith in developing the model presented here. For their helpful
comments on earlier drafts we thank Peter B. Clark, Steven W. KohIhagen. Steven A. Symansky,
Edwin M. Truman and an anonymous referee, as well as J. David Richardson and other participants at
the 1980 NBER Summer Institute in International Studies. Any errors that remain arc, of course. our
own. Robert G. Murphy and Kathleen H. Brown provided excellent research assistance. The views
expressed in this paper arc our own and do not necessarily represent the views of the Federal Reserve
Board or anyone else on its staff.
40 Flrcctuationsin the Dollar

long-run portfolio balance. Unexpected changes in the current account are assumed
to provide information about shifts in underlying determinants that necessitate
offsetting shifts in the real exchange rate in order to maintain current account
equilibrium in the long run.’ Current account equilibrium is defined by the rate at
which domestic and foreign asset holders wish to accumulate (or decumulate)
domestic assets net of foreign assets in the long run, where nominal asset stocks are
assumed to be growing in long run equilibrium. The expectations relationship
between the current account and exchange rate is distinguished from the more
conventional relationship underlying the portfolio balance model, in which
(assuming static expectations) current account flows affect exchange rates through
their impact on wealth stocks and the currency composition of portfolios across
countries.* This conventional relationship is also included in our model, through
the specification of the exchange risk premium as a function of factors that affect
changes in wealths and asset supplies.
Our empirical results are given in Section II and our conclusions in Section III.
The results indicate that real factors were at least as important as monetary factors in
causing fluctuations in the weighted average dollar during the 1970s. The equation
estimates suggest that the current account affected the exchange rate predominantly
through its impact on expectations about the long run equilibrium real exchange
rate. This result is substantially a reflection of the period from the end of 1976 to the
end of 1978 when the dollar depreciated steadily in real terms as the United States
ran a series of large current account deficits. Although we found no statistically
significant evidence of risk premia, the effect of short run private portfolio
rebalancing, in principle, would have worked in the opposite direction during that
period, causing the dollar to appreciate.3

I. Theoretical Structure
Our exchange rate equation is derived initially from the open interest parity
condition:

(1) E (A4 =r--r*

where the expected change in 2, the log of the spot exchange rate (in terms of
domestic currency per unit of foreign currency) is equal to the home minus foreign
interest differential. Later we will relax the assumption of perfect substitutability of
assets underlying this condition and allow for the existence of an exchange risk
premium. The rest of this section is devoted to the specification of exchange rate
expectations, followed by a description of the risk premium.

I. A. Expectations Scheme
To identify the expected exchange rate change we begin with Frankel’s (1979)
scheme and assume that the expected rate change is a function of the gap between
the current spot rate and the long-run equilibrium rate, plus the expected rate of
change in the long-run equilibrium rate:
(2) E(A.r)=8(1-I)+E(A.?J
where “-” denotes equilibrium values. The spot rate can deviate from equilibrium
because prices are sticky. (This point is reviewed below.) The parameter 8
represents a speed of adjustment: it is equal to 1 divided by the number of quarters it
is expected to take z to return to i following a shock.
The equilibrium exchange rate is defined as the rate that is consistent today with
 PETER HOOPER APU‘DJOI-IN MORTON 41

Definition of Variables

= Current account (billions of dollars, quarterly rate)

; = Unexpected transitory component of current account
EO = Expectations operator
I = Intervention (official purchase of dollars, quarterly rate)
= Log of money supply
p” = Log of consumer price index
4 = Log of real exchange rate (=J-p+$)
r = Interest rate (3-month rate at quarterly rate)
5 = Log of spot exchange rate (home currency (dollar)/foreign currency)
t = Time trend (also time subscript)
TB = Trade balance (billions of dollars, quarterly rate)
X = Vector of exogenous variables that have Permanent effect on C
X = Vector of exogenous variables that have transitory effect on C
Y = Log of real GNP
)‘T = Trend in nominal GNP
T( = Inflation rate (at quarterly rate)
,,*,r = denotes foreign variable
,,_,,
= denotes long-run equilibrium rate

a Monthly rate used in monthly equations.

current and expected future equilibrium values of its underlying determinants. To

derive these determinants we divide the equilibrium nominal rate into its relative
price and real components:
(3) r=(p-p*>+q
In the absence of changes in the equilibrium real exchange rate (6, the first
difference of (3) is a long-run purchasing power parity condition.
To simplify the model we assume that the expected future change in the
equilibrium real exchange rate is zero, so that qshifts over time only in response to
unexpected developments (as discussed below). The expected change in fcan then
be defined in terms of the expected equilibrium inflation differential:

(4) E(A+n-A*
Substituting (2) and (4) into (1) and rearranging, we derive the spot exchange
rate equation:

(5) r=i-;[(r-+(r-a*)]

This equation states that the spot exchange rate moves directly with changes in the
underlying equilibrium rate and with changes in the real interest differential. We
now turn to a more detailed specitication of the components of the underlying
equilibrium rate.

I. B. Equilibrium ReIative Prices

To determine equilibrium prices we make the standard monetary substitution.
Home and foreign money market equilibrium conditions are written:
(6) m-p=ay-/Jr

(7) m*-p*=ay*-jW
42 Fhctnations in the Dollar

With money demand parameters a and fl assumed identical across countries, and
with the interest differential assumed to equal the inflation differential in
equilibrium, expected equilibrium relative prices are derived by subtracting the
equilibrium values of (7) from those of (6), and rearranging:
~--p*&j_** - aF-J*) + fi(f - n*)
(8)
At this point an exchange rate equation identical to Frankel’s can be derived from
equations (3>, (5) and (a), under the assumption that the equilibrium real
exchange rate is constant.
Before specifying the equilibrium real exchange rate it would be useful briefly to
review the dynamics of overshooting, illustrating how the spot race responds to a
monetary shock. Figure 1 illustrates possible adjustment paths of interest rates and
exchange rates following an unexpected decline in the ratio of home to foreign
money stocks. Initially, the interest differential is assumed to be at its long run

SWtTCNTtl
Interest
oiwential
(r-4

Long LquibitiM
interest bfferenticll =
long run intiatiotl
differential cn - f*)

Exchange
Rate
(9

I I I 1
Time
t0 11 t2

FIGURE 1.
 PETERHELPER AND JOHN MORTON 43

equilibrium level (as defined by the equilibrium inflation differential), and the
exchange rate is assumed to be on its expected equilibrium path-the level of which
is defined in equation (3), and the slope of which is defined in (4). With the
unexpected drop in the relative money supply, the equilibrium relative price level
falls from point a to point b. Actual prices are sticky, causing a decline in relative
money in real terms. This in turn causes the interest differential to rise temporarily
above its long-run equilibrium level, to (r-f*),,. The rise in the domestic interest
rate relative to foreign interest rates induces an appreciation of the home currency
due to interest arbitrage-the exchange rate must fall below its new equilibrium
level (at point b) by enough to achieve an expected depreciation of the home
currency that offsets the change in the interest differential. As relative prices fall to
their equilibrium level over time, the real interest differential falls and the domestic
currency depreciates (the exchange rate rises) to its equilibrium level. If 8 is large
and the real interest differential is closed quickly, by ti, the return of the exchange
rate is rapid, and the initial drop of the exchange rate below its equilibrium level (the
degree of overshooting) is small (distance bc). If, however 8 is small and the system
returns to equilibrium slowly, so that the real interest differential does not disappear
until tr, the initial fall of the exchange rate below its equilibrium level is relatively
great (distance bd).

I.C. Equilibrium Real Exchange Rate

The equilibrium real exchange rate is defined as the rate that equilibrates the current
account in the long run. The long-run equilibrium or ‘sustainable’ current account,
in turn, is determined by the rate at which foreign and domestic residents wish to
accumulate or decumulate domestic-currency-denominated assets net of foreign-
currency-denominated assets in the long rut~.~
The relationship between the real exchange rate and the current account is
derived from the current account equation:
t

(9) C-,- riqr-i+f(X),+f,(X),

c
i-0
Where C, the current account balance, is a function of current and lagged values of
the real exchange rate and a vector of other variables that affect the current account,
some of which are transitory or cyclical in nature (z), others of which are
permanent or secular (X), and all of which are assumed exogen0us.j In long-run
equilibrium, we have:

where y=cy; is the long-run response of the current account to the real exchange
rate. Assuming the Marshall-Lerner condition holds, we expect y > 0. Solving (10)
for 4 gives:
, ,

where the equilibrium real exchange rate is determined by the desired rate of net
foreign asset accumulation in the long run (C) and all nontransitory factors other
than the real exchange rate that affect the current account (X).
To simplify the analysis we assume first that C is constant over time.6 This allows
44 Fluctuations in the Dollar

us to relate changes in qdirectly to changes in X. Taking the first difference of (11)

we have:
- _
(12) qr-qr-I= +O,-Jl~x~,_,l
We also assume that forward expectations about X are static. This is partly to be
consistent with our earlier assumption that E(Aq3=0, and partly to allow us to
infer changes in f,(X) directly from nontransitory unexpected changes in the
current account:’
(13) fi(x>,-f,(x>,-,=c,--,-,(c,)--,

where E,_i(C,) is the expectation in period t- 1 about C in period t, and C is the

transitory component of the unexpected change in C.
Combining (12) and (13) we have:

(14)
_ _
qr-q/-1= -+-&&)-Cl
which relates changes in the equilibrium real exchange rate directly to movements
in the current account. Integrating (13) over time yields:
I

(15) (C&,---E r-,-r (C,_,>-L]

In (15) the equilibrium real exchange rate in period t is expressed as a function of

an initial equilibrium rate and the cumulative sum of past nontransitory unexpected
changes in the current account balance.
In order to make the model empirically tractable the expectations and transitory
elements in (14) must be identified. This is done with two additional simplifying
assumptions. To identify the expected current account we assume that a constant
fraction L of the gap between the actual and equilibrium current account is expected
to be eliminated in the next period:

(16) E,_,(c,)=c,_,+1(C-C,-,)

This expectations hypothesis can be shown to be consistent with a restricted form

of the current account equation (9) under certain conditions.8 To identify
transitory changes in the current account we assume that a constant proportion ?I of
any deviation of the current account from its expected level is transitory:

(17) C~=rl[c,--&,(c,)]
Substituting (16) and (17) into (15), our equilibrium real exchange rate
equation becomes:

(18) q,,=+---- ‘,” ’ [C,_;-(l-I)c,_,_;]+~t.~

c
i=o
Equation (18) expresses the equilibrium real exchange rate as a function of a base
period rate, the cumulative partial first difference of the current account, and the
cumulative equilibrium current account (C-t). In the special case where the current
account is expected to return to equilibrium in the next period (n=l) and the
equilibrium current account is zero, the equilibrium real exchange rate becomes a
linear function of the cumulative current account.
Given the expectations scheme outlined earlier, the spot rate moves directly with
 PETER HELPER AND JOHN MORTON 45

changes in expectations about the equilibrium real exchange rate. Under the
assumptions we have made, these expectations are directly affected by changes in
the current account. Since current account data are released with a lag of about one
quarter, the current account can be expected to affect the spot rate through
expectations with a one quarter lag.
By substituting (3), (8) and (18) into (5), our spot exchange rate equation
becomes:

(19) s=fi--A* -a(+J*)+B(7f--*)+~o

-y
c [C_;-(l-n)c-;-,)+~C~t-$[(T-n)-(~-lt*)~
where z is expressed as a function of (1) relative money, income and inflation rates as
determinants of equilibrium relative prices, (2) cumulative movements in the
current account and a time trend, as determinants of the equilibirum real exchange
rate, and (3) the real interest differential, which identifies deviations of the spot rate
from its expected equilibrium.

I.D. Risk Premium

To this point we have assumed that the short-run risk premium is zero, or that
assets denominated in different currencies are perfect substitutes in the short run.
Portfolio preferences only influence the exchange rate to the extent that they enter
into determination of the equilibrium real exchange rate by identifying the long-run
equilibrium current account. 9 We now relax this assumption and allow for
imperfect substitutability of assets in the short run and the existence of exchange
risk premia. This is implemented by appending a risk premium to equation (1):

(20) E(A+r--T*+#J
where 4 is the premium that asset holders demand on domestic currency assets
relative to foreign currency assets, given existing weahhs, asset stocks and expected
relative rates of return on those assets.
Dooley and Isard (1979) have shown, conveniently, that the portfolio balance
model can be solved for the risk premium. In reduced form the model expresses the
risk premium as a function of factors, other than expected relative rates of return,
that determine the supply and distribution of outside assets. These include
cumulative government budget deficits, official intervention and current account
baIances. We employ an abbreviated specification, expressing the risk premium as a
linear function of cumulative current account and intervention flows and an initial
condition:‘O

4,=40-6 (C_,+l_,>
(21)
c

The sum of the current account plus official intervention purchases of domestic
currency (I) defines net private capital flows, or shifts across countries in the
quantities of home currency assets relative to foreign currency assets held in private
portfolios. These shifts are accommodated through changes in the risk premium.
An increase in the current account, for example, reduces foreign holdings of
domestic assets net of domestic holdings of foreign assets, which is accommodated
by a reduction of the risk premium.”
 46 Flucturrtions in the Dollar

.A spot exchange rate equation similar to (5) can be derived by substituting (2)
and (4) into (20):

(22) r=i-$[(r-r)-(*-n*~]+~

Next, substituting (3), (8), (18) and (21) into (22), we derive a fully specified
spot exchange rate equation:

(23) s=ti-** - acv_-J*> + &- fl*j + qo- -Qz_;_,]

+
1-q 40’6 cc-,+I-,)
--it.t-~[(~-n)-(~-lr*)]+8-8
Y c
In (23) an increase in the risk premium (induced by a decline in the current account
or official intervention) leads to a depreciation of the domestic currency.
The current account now affects the spot exchange rate through two channels:
expectations and short run portfolio rebalancing. In the former case the
announcement of a current account deficit that is unexpected and nontransitory
shifts the spot rate (through changes in expectations about the equilibrium real
exchange rate) by enough to return the current account to its long-run equilibrium
or ‘sustainable’ level. In the latter case, if the current account deficit is not financed
by official intervention during the length of time it takes to return to equilibrium,
the necessary private financing is attracted with an increase in the risk premium.
The risk premium causes the real exchange rate to overshoot its expected
equilibrium level. This may cause the current account to oscillate as it returns to
equilibrium. The real exchange rate remains above equilibrium until the current
account has been reversed by enough to return private portfolios to desired
compositions at existing rates of return and a zero risk premium. At that point the
real rate has returned to its expected equilibrium level.
Finally, the effects of the current account through, alternately, expectations and
short run portfolio rebalancing are distinguished empirically by several factors.
First, changes in expectations are likely to influence the exchange rate with a lag,
reflecting the lag in the release of current account data, whereas portfolio
rebalancing is in response to current flows without a lag. Second, intervention,
which dominated net current account flows for significant periods during the 197Os,
affects short run portfolio rebalancing but should not affect expectations about the
equilibrium real exchange rate. ‘* Third, if the current account is expected to
respond slowly to changes in the real exchange rate (i.e., E,< l), the expectations
specification involves the cumulation of a partial first difference of the current
account whereas the risk premium specification involves simply the cumulated
current account.

II. Empirical Results

In this section we report the results of regressions run with several versions of the
model developed in Section I. In order to avoid potentially severe multicollinearity
in estimation, the model was estimated in two stages. In the first stage, the real
exchange rate equation (18) was run to obtain estimates of the expectations
parameter 1 and the equilibrium current account c. In the second stage, the
nominal exchange rate equations (19) and (23) were run with the values of 1 and
c constrained to the estimates obtained in the first stage.
 PETER HOOPERAND JOHN MORTON 47

In each case the empiiical application tvas td tht foteign exchange value of the
dollar as measured by an index of the dollar’s weighted-average exchange value
against 10 major foreign currencies. I3 This is a departure from many previous
empirical studies, which have focused on bilateral exchange rates. The use of a
weighted-average exchange rate has the advantage of including third country
effects that are normally omitted. This consideration is especially important in
estimating the exchange rate impacts of the current account. The current account is
influenced by many bilateral real exchange rates, so that shifts in the current account
presumably influence expectations about not just one but all of these exchange
rates. Moreover current imbalances can involve shifts in portfolio holdings across a
number of countries, potentially affecting risk premia on assets denominated in a
number of different currencies. To explain changes in the bilateral dollar/mark rate,
for example, it is not clear whether the appropriate empirical specification would
include the US current account, the German current account, the bilateral
US-German current account, or some combination of all three.

I1.A. Real Exchange Rate Equations

The real exchange rate equation (18) was estimated over the period 1973 42 to
1978 44. As a proxy for the equilibrium real exchange rate we used the weighted
average spot rate times the ratio of weighted average foreign consumer prices to US

TABLE 1. Estimation results for real exchange rate

equation.’ (t-ratios in parentheses)

Constant [CClb time R2 DW

(1.1) (i.=O) 4.63 1.07 0.0033 0.358 0.55

(175.3) (0.66) (3.21)
(1.2) kO.25) 4.58 -2.39 0.0046 0.494 0.91
(202.5) (2.44) (3.88)
(1.3) (120.5) 4.57 -2.20 0.0060 0.651 1.15
(262.4) (4.19) (5.89)
(1.4) (110.75) 4.58 -1.75 0.0069 0.721 1.29
(306.4) (5.20) (7.19)
(1.5) (1-l) 4.58 -1.41 0.0074 0.756 1.39
(336.2) (5.81) (7.99)
(1.6) (1~1) CUBI
4.56 -1.12 -0.0013 0.739 1.29
(317.9) (5.51) (0.94)

a Estimared by ordinary least squares over the period 1973 42

through 1978 44.

bWI --C[(~)_,-(1-~)(~)_,_.1
,

c CPI- -C[(z)_;-(l-#-,-J
i
where TB=tnde balance.
 48 Fhctuahons in the Dollar

consumer prices. Several empirical specifications were tested. In particular, we

experimented with deflating the current account variable by trend growth in
nominal GNP to allow for some change in the equilibrium current account over
time. (In developing the model in Section I we assumed for the sake of simplicity
that the desired rate of private net foreign asset accumulation in the long run (C) is
constant over time. If c is nonzero, it is reasonable at least to test for changes in that
variable in line with growth in the scale of total nominal portfolios, particularly
during a period of significant inflation.) Deflating the current account by trend
nominal GNP improved the statistical fit of the real exchange rate equation, and the
results given below include this adjustment. Equation (18) was estimated for
different values of 1 ranging between 0 and 1. The results are shown in equations
(1 .l)-( 1.5) in Table 1. The equation’s statistical fit is maximized for a value of A= 1,
implying that a deviation of the current account from equilibrium is expected to be
eliminated in one quarter. Based on equation (18) above and (1.5) in Table 1 (with
A= l), the equilibrium current account is equal to O.O052YT, or about l/2 per cent
of trend nominal GNP.”

1I.B. Nominal Exchange Rate Equations

The nominal exchange rate equation we estimated was derived by substituting the
first-stage estimates of A and c into equation (23), obtaining:

(24) s=ao+at(ti-fi*)+a;?fi-f+)+a3(d-7t*)+a4 (C_,/YT_;-0.005)

c

fas[(r-7t)-(r*-fl*)]+at, (C,+I,)/YT,
c

where we expect: 40 1-V

ao=qo+-
e --Y<O
a4=

For purposes of estimating (24) all foreign variables were defined as lo-country
geometrically weighted averages, using weights employed in the exchange rate
index.‘j Equilibrium money supplies and real incomes were represented by
four-quarter weighted moving averages of current and past values, using declining
weights.16 To allow for the possibility of simultaneity between exchange rates and
several right-hand-side variables (including money supplies, interest rates and
intervention), instruments were used for those variables in estimation. This made
little difference to estimation results, and ordinary least squares results alone are
reported blow (except in the case of intervention, where both are reported). We also
tested both Ml and M2 definitions of money supplies. The Ml equations had
superior statistical properties and’are reported below.
Equation (24) was estimated first with the risk premium assumed to be zero.
 PETER HOOPER AND JOHN MORTON 49

Regressions were run using both quarterly and monthly data over the period from
1973 42 to 1978 44. In the monthly equations the cumulative current account term
was replaced by the cumulative trade balance. ” The trade balance specification also
was run quarterly for comparison with the quarterly current account results. Each
equation was estimated twice: with the coefficient on relative money supplies first
unconstrained and then constrained to unity as suggested by the underlying
thcory.18
The results in Table 2 generally conform to our theoretical priors. On average,
the equations explain about 80 per cent of the monthly and quarterly variance in the

TABLE 2. Estimation results for nominal exchange rate equation without risk premium?
(t-ratios in parentheses)

(t-ff)-
Constant k--R* j-y* R- 7c*b (fl- W*)b C(C/ Y-T- 0.005) NO.

(ad (ad (az) (a) (ad (aa) R2 DW obs.

Quarterly data
(2.1) 4.53 0.54 -1.46 4.13 -0.13 -1.47 0.784 1.76 23
(150.2) (4.40) (3.00) (3.37) (0.24) (4.41)
(2.2) 4.45 1.0 - 2.00 6.32 -1.51 -2.03 0.917 1.44 23
(177.4) (3.29) (4.52) (2.82) (5.28)
ZIYi’T)
(2.3) 4.52 0.69 -1.71 4.43 -0.11 (4:48) 0.788 1.76 23
(151.7) (4.91) (3.45) (3.72) (0.21)
(2.4) 4.47 1.0 -2.11 5.46 -0.98 - 1.62 0.942 1.61 23
(194.7) (4.14) (4.50) (2.32) (6.85)
Monthly data
(2.5) 4.54 0.45 -1.36 3.31 -0.11 ZiygT 0.781 0.63 70
(282.6) (7.13) (5.44) (4.84) (0.39) (8:05)
(2.6) 4.43 I.0 -1.93 6.05 -1.71 -2.02 0.891 0.41 70
(321.3) (5.45) (6.74) (4.90) (8.15)

a Estimated by ordinary least squares using quarterly data for 1973 42 through 1978 44 and monthly
data for March 1973 through December 1978.
” Fx
.P fessed at annual rates in estimation.

weighted average dollar over the sample period. All of the coefficients have the
expected sign and all except that on the real interest differential are significant at the
1 per cent level. Equations (2.1) and (2.2), with the cumulative current account
variable, are very similar to the corresponding quarterly equations with the
cumulative trade balance variable (2.3) and (2.4). This suggests that unexpected
changes in the current account and the trade balance serve equally well as indicators
of real shocks requiring adjustments in the real exchange rate. The quarterly and
monthly equations using the trade balance are also very similar in terms of the size
and significance of coefficients and overall explanatory power. They differ sharply,
however, in the degree of autocorrelation of their error terms. The low
Durbin-Watson statistics for the monthly equations indicate strong (positive)
serial correlation of errors, which is absent in the quarterly equations. This result
suggests that transitory shifts in central bank intervention and other variables
50 Fluctuations in the Dollar

excluded from the model may have significant impacts on monthly exchange rate
movements but average out over longer periods and have no systematic influence
on quarterly exchange rate movements.
Estimation results for quarterly equations including the risk premium are shown
in Table 3. Equation (3.1), which is the same as (2.1) in Table 2, is presented for the
sake of comparison. In equation (3.2) the risk premium is added, but the
expectations variable (cumulative current account) is not. Both are included in (3.3)
and (3.4). In estimating these equations instruments were used for intervention to
correct for simultaneity between that variable and the exchange rate (except in
equation (3.3), where instruments were not used). The instruments included lagged
values of exchang, e rates and official reserves; they did not affect the results
significantly.

TABLE 3. Estimation results for nominal exchange rate equation with risk premium.’
(t-ratios in parentheses)

(r-It)- ~(k-/cr
Constant 6-S j-y- It-fl*b (r*-7rf)b -0.005) x(c+I)/YT
Go) (al) (a2) (a31 (4 (4 b-4 J? DW Rho

(3.1) 4.53 0.54 -1.46 4.13 -0.13 -1.47 0.784 1.76

(150.2) (4.40) (3Jw (3.37) (0.24) (4.41)
(3.2) 4.51 0.52 -1.04 4.21 0.60 0.93 0.627 1.60 0.59
(51.3) (1.26) (0.78) (1.80) (0.78) (1.00) (3.41)
(3.3) 4.55 0.86 - 2.00 1.70 -0.15 -1.78 1.37 0.815 1.75
(154.5) (4.37) (3.79) (1.02) (0.30) (5.14) (1.96)
(3.4) 4.55 0.77 -1.84 2.41 -0.15 -1.69 0.97 0.78 1.87
(131.9) (2.56) (2.72) (0.98) (0.27) (3.90) (0.82)

’ Estimated by OLS, except (3.2), which was estimated using Cochrane-Orcutt correction for serial
correlation. Equation (3.4) was estimated using instruments for intervention whereas equation (3.3)
was not. All were estimated with quarterly data for 1973 42-1978 44.
’ Expressed at annual rates in estimation.

A comparison of the results across equations in Table 3 suggests that the current
account influenced the exchange rate predominantly through expectations about
the long run equilibrium real exchange rate. In none of the equations did the risk
premium coefficients have either the expected sign or a value significantly different
from zero.i9 Moreover, the total explantory power of the equations was noticeably
reduced when the risk premium was substituted for the expectations term (equation
(3.2)).
The estimated coefficients of equation (2.1) and (2.2) in Table 2 are interpreted in
Table 4 in terms of the exchange rate impacts of unit changes in various explanatory
variables. The coefficient on the real interest differential (l/e) is an estimate of the
speed of price adjustment-the time it takes prices (and the exchange rate) to return
to equilibrium following a shock. The estimate given in equation (2.1), in which the
money supply coefficient is unconstrained, suggests that prices return to equilib-
rium in about one month (.l year). The other equation, in which the relative money
supply coefficient is constrained to 1.0, suggests a more plausible adjustment period
of l+ years.
 PETER H~~PERANDJOHN AMORTON 51

The coeflicient on the cumulative currerit accoutii, - (1 - q)/y, is a combination

of the proportion of changes in the current actoimt deemed transitory (q) and the
long run response of the current account to the real exchange rate (;1.>.The estimate
in equation (2.2) suggests that a $1 billion increase in the US current account
induces a 0.4 per cent appreciation of the dollar. Using an independent empirical
estimate of y equal to 1.5, we derive a value of ‘1 equal to 0.4.m This implies that on
average 60 per cent of unexpected current account changes are viewed by market

TABLE 4. Interpretation of coefficient estimates for norGal

exchange rate equation.’ (Percent change in weighted average
dollar price of foreign currency)

Change in Explanatory
Variable Coefficient Eq. (2.1) Eq. (2.2)

percent increase in
US money supply (al) 0.5 1.0
percent increase in
US real GNP (02) -1.5 -2.0
percentage point increaseb
in expected US inflation
rate (a3) 4.1 6.3
$1 billion increase’ in
cumulative US current (a.+)=- -1-V -0.3 -0.4
account Y
I percentage pointb
increase in real short-
1
term US interest (as)=- - -0.1 -1.5
rate e

’ Estimates are based on equations (2.1) and (2.2) in Table 2.

b At an annual rate.
’ Current account impact computed at 1978 44 trade levels.

participants as arising from permanent real shocks, while 40 per cent are viewed as
arising from transitory factors not requiring adjustments in the real exchange rate.
Figure 2 illustrates the relative importance of factors causing changes in the
dollar’s average foreign exchange value over the period 1973-1978. Line A shows
the actual path of the Federal Reserve Board’s index of the weighted average dollar
during this period. (Note that this index is expressed in terms of foreign currency
per dollar.) Line B traces the path of equilibrium relative prices. This represents the
course that the dollar index would have followed if it had been influenced only by
monetary factors, as measured by the determinants of money demand and supply.
Line C plots the movement of the equilibrium real exchange rate. This represents
the path the dollar would have followed if it had been influenced only by real
shocks, as measured by the cumulative current account variable. Line D shows the
path the dollar would have taken if it had been affected only by changes in real
interest rates. Figure 2 suggests that the dollar’s fluctuations during this period
were caused in about equal part by monetary shocks, current account shocks and
52 Fhctnations in the Dollar

changes in the real interest differential. The average absolute quarterly percentage
exchange rate changes due to these three factors were 1.8 per cent, 1.6 per cent and
1.3 per cent respectively, Based on our estimates, about 80 per cent of the dollar’s
sharp decline between 1976 44 and 1978 44 was due to real factors (reflected in the
series of large US current account deficits during that period) and the remaining 20
per cent was due to monetary factors (mainly an increase in the expected US
inflation rate).

r
INOEX 1973 02=100
130

120

~~~~~~~~~~at~

90 - .%* exchange rate*

‘X.
*...
-.,.
.‘*. C Equilibrium real
60 -
exchange rate

70 I I I I I 1
1973 1974 1975 1976 1977 1976

l qWnW werwer 01Federal R~rerve BMud index aopmst I 0 cwrenc~es m terms of foragn
currcncy’dollar

FIGURE 2. The Determinants of Fluctuations in the Dollar’s Weighted

Average Exchange Rate

III. Conclusions

In this paper we have developed a model of exchange rate determination that

extends the Dornbusch-Frankel model to allow for large and sustained changes in
real exchange rates. These real exchange rate changes are related primarily to
movements in the current account, both through expectations about changes in the
long run equilibrium real exchange rate (based on information derived from the
current account), and through changes in the risk premium. In empirical tests of the
model applied to the weighted average dollar we were able to explain, expost, a
large proportion of the monthly and quarterly variance in exchange rates during the
1970s. Well over half of this variance reflected movements in the real exchange rate
caused by shifts in the current account and changes in real interest differentials.
The current account appears to have affected the exchange rate predominantly
through changes in expectations. We found no significant empirical evidence of risk
premia in the short run. The failure to find a significant risk premium effect tends to
reject the importance to exchange rate determination of portfolio preferences in the
short run, while the presence of significant current account effects through
expectations tends to confirm the importance of these preferences in the long run.
That is, asset holders appear to have been willing to finance transitory deviations of
 PETER HELPER AND JOHN MORTON 53

the current account from equilibrium at unchanged exchange rates. However, the
prospect of sustained deviations from equilibrium, that would have resulted in
continual changes in portfolio compositions, necessitated adjustment of the
exchange rate.
Finally, to keep our model simple and empirically tractable, we made a number of
strong assumptions concerning the nature of expectations formation and the
structure of the underlying current account model. In particular, we assumed that
the equilibrium current account, as determined by private net foreign asset
demands in the long run, is constant over time (or at most moves steadily along a
trend path). We also assumed that expectations about determinants of the current
account other than the real exchange rate are static, and that transitory or cyclical
changes in the current account are proportional to total changes. These
simplifications may have excluded important sources of variance in exchange rates
which could have resulted in some structural instability in our model.*’ A useful
extension of the work we have presented here would be to develop a more detailed
empirical specification of both the current account and the interaction between the
real exchange rate and other determinants of the current account under rational
expectations.

Appendix
ri proof of equation (13) goes as follows. First, raking the expectation of C,, from equation
(9). we have: I

(A.1) is,-t(G)=&I[ Yiq,-i+ji(X),+_M~)r

c
i-0
or, as described below:
,

(‘4.2) Et-1(G)= yiqt-i+f((x),-I +jm,-1

c
i-0

The values of f!(X) and /s(X) are assumed to be announced at discrete intervals-for
_
simplicity, at the end of each period. At the end of period t- l,J(X),_l and&X),--l are
announced and are expected to be the same in period t. Also, from equation (I 2), q adjusts
to a new level, consistent withf,(X) ,__Iand remains at that level untilj;(X),is announced at
the end of period t. Hence, the expected value of C, at the end of period t- 1 is a function of
known values of q, and offt(X) ,__Iandfr(X),_l (where X and X are assumed to follow a
random walk, so that expectations about them are static).
Next, we define C,;, the unexpected transitory component of C, as:

(‘4.3) G=%+ ~,-,Cf2(~‘)3,=ft(8),-~(~),-1

Substituting (9), (A.2) and (A.3) into the right hand side of (13) yields:
t

(A.4) fi(-qt-jxxLl= rtq,-i+_fi(x),+f2(8),

c
i-0
,

- Yiqt-i-h(x),-1 -fi(~),-r-fi(~),+/,(~),-I
c
i-0

which collapses to:

(A.5) Ii(X),-l(X),-1 -f(X),-J(X),-I
54 Fluctuations in the Dollar

Notes

1. Similar theoretical models relating the current account to the real exchange rate through
expectations have been advanced recently by Isard (1980), Dornbusch (1980). Dombusch and
Fischer (1980) and Rodriguez (1980).
2. See, for example, Girton and Henderson (1973), Branson cl. al. (1977). Dooley and Isard (1979)
and Porter (1979). With the expected future spot rate tied down by an expectations scheme similar
to the one developed here, the portfolio balance model can be extended to look very much like the
model we derive.
3. The risk premium is specified as a function of the sum ofcurrent account plus intervention. which
defines changes in private net claims on foreigners. During 1977-1978 official purchases ofdollars
by central banks were more than double the cumulative US current account deficit during the
same period, so that the sum moved substantially in the oposite direction to the cumulative
current account.
4. To this point we have assumed, implicitly, that assets denominated in different currencies are
perfect substitutes. This implies that current account imbalances are financed at unchanged
exchange rates, since asset holders are assumed indifferent to the currency-denomination of the
wealth accumulations or decumulations associated with the current account flows. We now
introduce the notion that asset holders are not indifferent or risk neutral in the long run. That is.
while they may be willing to absorb some variance in their portfolios to accommodate asset shifts
associated with current account deficits in the short run (with a zero risk premium), they are not
willing to do so indefinitely.
We allow for the possibility of a nonzero current account in long-run equilibrium because
nominal asset stocks arc growing over time (consistent with the existence of inflation in the long
run). A nonzero current account in equilibrium could reflect, for example, ‘transactions’ demands
for assets denominated in particular currencies to facilitate international trade. This treatment
differs from more standard long-run portfolio balance models as described by Kouri (1976) and
Henderson (1977). in which steady-state equilibrium is defined as a situation where wealth stocks
are at desired levels, all output is absorbed and current accounts are zero.
5. By ‘transitory’ we mean factors (such as cyclical swings in income) that do not affect current
account flows permanently.
6. This assumption is relaxed below to allow for trend changes in net foreign asset demands in line
with trend increases in nominal international transactions and wealth stocks.
7. h proof of equation (13) is given in the Appendix. As outlined below we employ the right hand
side of (13) to identify changes in i. This is done partly to keep the model simple and partly
because we believe the right hand side is easier to measure empirically than the left hand side. In
preliminary empirical tests attempting to relate the real exchange rate to representative variables
in X (including domestic and foreign real incomes and oil prices) we failed to obtain statistically
significant results.
8. This expectations hypothesis is fuily ‘rational’ only with respect to a model in which the current
account responds completely within one period to changes in q. X and X (i.e., i-1). and where
X and 8each follow a random walk. If C responds to q with a distributed lag, the value of 1 is
only an approximation to the distributed lag parameters, and equation (16) provides only an
approximation to rational expectations about changes in C based on past changes in q.
9. See Note 4.
10. Government budget deficits and total private wealths were excluded initially because of
difficulties involved in obtaining quarterly data across countries. More recent tests including
these variables for several major industrial countries did not yield empirical results that differed
significantly from those reported in Section II. See Hooper, Haas and Symansky (1981).
11. We assume that domestic residents have a relatively strong preference for assets denominated in
domestic currency and foreign residents strong preference for assets denominated in foreign
currency. If the current account shifts into de&it and increases foreign holdings of domestic
assets, foreign portfolio managers will sell off some of the newly acquired domestic assets, causing
the domestic currency to depreciate. Hence in equation (21) we expect 6 > 0. This relationship is
weakened to the extent that current accounts are financed by changes in domestic holdings of
foreign assets denominated in domestic currency.
12. This assumption is consistent with either ‘leaning against the wind’ or reserve-targeting
 PETER HWPER AND JOHN IMORTON SS

intecvcmion behavior, where central banks are not expected to intervene indefinitely in an
attempt to maintain a pacticular rate.
13. We employed the Federal Reserve Board’s exchange rate index, which measures the weighted
average foreign exchange value of the dollar against the currencies of Belgium, Canada, France,
Germany, Italy, Japan, the Netherlands, Sweden, Switzerland and the United Kingdom. The
weights used ace multilatecai trade shares. (See Hoopec and Morton (1978).) This index, which is
expressed in terms of foreign currency/dollar (and is illustrated that way in Figure 2 below), was
inverted for our regressions, to be consistent with the theoretical model developed in Seetion I.
14. From equations (1.5 in Table 1) and (18)-given the normalization of C by YT-we have
h?/YT I 0.0074/1.41 = 0.0052. or for i. = 1, c z 0.0052YT.
15. See Note 13. The data employed in estimating equation (24) included for the United States and
each of the ten major foreign industrial countries: consumer price indexes, real GNPs. Mls,
3-month CD or interbank loan rates (or nearest equivalent), long term government bond rates,
current account and trade balances (United States only), and US plus foreign official intervention,
were all obtained from the Federal Reserve data bank. The intervention data employed ace
confidential. Sepacate tests using published IMF data on official reserve changes did not
significantly alter our results.
16. This proxy was used in an attempt to smooth out transitory quactec-to-quarter fluctuations in
those variables. The relative weights used, beginning with the most recent. were 4, 3.2. 1.
17. The monthly equations were run to see if increasing the number ofdegrees of freedom would alter
the results significantly. An equilibrium trade balance was estimated in the same manner as the
equilibrium current account. The estimated equation is shown at the bottom of Table 1. This
yielded an estimate of the equilibrium trade balance that was not significantly different from zero.
18. The constraint was imposed by moving ni--ni* to the left-hand side of the equation. Note that for
this reason the /?s statistics for the constrained and unconstrained equations ace not comparable.
19. Failure to find significant risk premium effects is consistent with the empirical results of both
FrankeI(1979a) and Dooley and Hard (1979).
20. The independent estimate of y was obtained from an empirical model of the US trade balance
described in Hooper (1978). The elasticity estimates given in that paper suggest that a 1 per cent
depreciation of the weighted average dollar in real terms would have induced roughly a $1.5
billion increase in the US current account balance at the average levels of US trade in the 1970s.
Given (1--)/y=O.4 from equation (1.2). and ?=1.5, we have (1 -_r1)/1.5=0.4, or ~=0.4.
21. A recent analysis by Meese and Rogoff (1981) of the post-sample forecasting performance of
several models of exchange rate determination, including the one developed in this paper,
suggests that these models suffer to varying degrees from structural instability.

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