The Current Experience with Floating Exchange Rates: An Appraisal of the Monetary Approach

When the simple quantity theory model is confronted with evidence from the current experience with exchange rates, problems arise. New theories have been constructed to correct this situation. Three alternative models are distinguished: 1. the equilibrium rational expectations version of the monetary approach, 2. currency substitution models, and 3. Dornbusch's disequilibirum model of exchange rate dynamics. A depreciation of the exchange rate will be associated with a decline in interest rates, but it is possible that a positive relationship exists between the long-term rate and the money supply. Estimates confirm the predictions of the Dornbusch model. Support is given for the monetary approach in general.