Balance of Payments and the Foreign Exchange Market: A Dynamic Partial Equilibrium Model

This paper develops a dynamic partial equilibrium model of the foreign exchange market extending the standard textbook model in two respects. First, capital account transactions are explicitly incorporated into the model, and secondly, 'rational' speculative behaviour is also introduced. At a point in time, or in a given day, exchange rate fluctuations are dominated by 'new information' that leads to revision of speculative expectations, as well as by other disturbances on the capital account. In the long run, fundamental factors, such as divergences of inflation rates and real changes influencing the trade balance, become relevant in determining the 'trend' of the exchange rate. A variety of exercises, and numerical simulations, illustrate the usefulness of the dynamic supply-demand model in understanding the behaviour of floating exchange rates in a world of high capital mobility.