Asset market approach to exchange rate determination

Abstract

<p>The paper provides an analysis of exchange rate determination using an asset market approach model. The analysis includes exchange rate response to changes in government policies which are unanticipated and to changes in government policies which are anticipated before they occur. It is shown that the announcement of an expansionary policy will cause the exchange rate to depreciate, which induces balance of trade surplus and hence, external assets accumulation, before the policy is implemented. Empirical results accord well with the model, in particular they establish the positive relationship between anticipated money and the spot exchange rate. The results also support the hypothesis that anticipated expansionary monetary policy has a smaller impact on the exchange rate than the effect of unanticipated expansionary monetary policy.</p>