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The Role of Trade Flows in Exchange Rate Determination: A Rational Expectations Approach

The purpose of this paper is to examine the interaction between the exchange rate and the trade balance within the framework of the portfolio approach to exchange rates and rational expectations. In a simplified linear version, it is shown that the difference between the spot exchange rate and its long-run equilibrium value is proportional to the current level of the trade-balance surplus normalized by the current stock of foreign-asset holdings. Therefore, the analysis provides some evidence in favor of the presumption that surplus country should have an undervalued currency (relative to its long-run level). The basic idea behind the analysis is that, in a world of high capital mobility,current flow payments disequilibria can be accommodated by capital flows without need, in principle, for exchange rate movements. Only if the public expects lasting change in the required rate of capital flows will exchange rates adjust, since in this case the expected time path of net foreign assets will be significantly affected.