Theoretical content of exchange rate theory

(A) price invariant currency model

After World War II, Mundell and Fleming introduced international trade and capital flows into the classical IS-LM model, and proposed a static Mundell-Fleming model. The model is the assumption of commodity price rigidity under the premise of currency market equilibrium derived from the exchange rate determination model, has a certain significance. However, the assumption of price constancy is obviously inconsistent with reality, which makes the model's practical application value limited.

(B) flexible price monetary model

In the 1970s, Frank Mussa and Belson assumed that the commodity market price adjustment is timely and complete, the capital market is highly developed and fully liquid, so the purchasing power parity is established, at the same time the interest rate parity is also established, and then the use of the typical monetarist analysis method, to get the commodity price elasticity under the conditions of the complete model. The exchange rate decision model between the two countries under the condition of perfect elasticity of commodity prices. The model highlights the role of monetary factors in exchange rate determination and movement. However, the model's assumption of perfect elasticity of commodity prices is also not in line with reality, and thus the model fails to pass the test in many occasions.

(C) Sticky price monetary model

In 1976, Dornbusch put forward the sticky price monetary model. He assumed that the capital market is fully liquid, assets can be fully alternative, short-term commodity price adjustment does not have full flexibility, thus purchasing power parity can only be established in the long term, and the short-term exchange rate can deviate from the long-term equilibrium value, deviation by the market first of all, the money market imbalances and expectations and other factors. According to the model, the capital market will react instantly to various internal and external shocks in the economy, and product prices are sticky, so there is a phenomenon of "overshooting" of the exchange rate in the short term, which explains to a certain extent that the exchange rate in the short term deviates from the long-term equilibrium exchange rate determined by the purchasing power parity phenomenon. The model is also called "dynamic Mundell-Fleming model". Unfortunately, on many occasions, its prediction and interpretation of the real exchange rate still appear to be a large deviation.

(D) REDUX model

In the 1980s, one of the major achievements of macroeconomics was the construction of a dynamic general equilibrium model with a solid micro-foundation, thus creating a "new open economy macroeconomics". 1995, Ob-stfeld and Rogoff*** proposed the same model. Rogoff*** proposed the REDUX model, which is an intertemporal equilibrium model. The model assumes that all product prices follow the law of one price, so that there is a purchasing power parity relationship between domestic and foreign price indices, and then extends the individual utility function in microeconomics to the typical domestic household's lifetime utility function, consumption function, and price indices to ensure that the household's utility is maximized through the optimal equilibrium of consumption, output, and money holdings, and then seeks the steady state value through intertemporal analysis to derive the market equilibrium value of the nominal exchange rate. Finally, through the intertemporal analysis to find the steady state value, so as to obtain the market equilibrium value of the nominal exchange rate. According to the model, the equilibrium nominal exchange rate is determined by the difference between the (logarithmic) equilibrium money supply and the equilibrium consumption demand of each country. The REDUX model has been improved by later generations to predict the short-term exchange rate with a certain degree of accuracy, and its conclusion that "in the long run the currency is neutral, and the over-adjusted exchange rate will gradually converge to the long-term equilibrium value" also has a certain degree of explanatory power for the nominal exchange rate trend in the long run. But overall, the model's explanatory power for exchange rate movements is not yet satisfactory.

We can easily see that, compared with the traditional theory of exchange rate determination, the modern theoretical model of exchange rate determination is more and more inclined to use general equilibrium analysis instead of partial equilibrium analysis, dynamic analysis instead of static analysis, and focusing on stock analysis instead of focusing on flow analysis, and the assumption that the premise is more and more close to the reality, and therefore, the nominal exchange rate of the explanatory power of the predictive power of the more and more strong. But unfortunately: in general, the modern theory of exchange rate determination for the nominal exchange rate of the explanatory power and predictive power there is still a large error.