Abstract
According to Taylor (1995), in the past twenty years exchange rate economics has been one of the most active areas of economics research. After the collapse of the Bretton Woods system, most industry countries floated their exchange rate. One of the oldest exchange rate models was based on the current balance model. According to this approach, exchange rate under floating regime is determined by the demand and supply of trade goods. However, the current balance model does not take into account of the capital flow between countries. After World War II ended, the capital flow has grown rapidly.
Moreover, its effect was large enough to be one of the major factors that caused the collapse of the Bretton Woods System (Harvey 1995). The popularity of the early model of exchange faded away since they do not recognise the role of the capital account. Later, the Mundell-Fleming model (Fleming 1962, Mundell 1963) constructed based on the earlier theories and incorporated the capital account effects through the current account since under freely float current account disequilibrium must be offset by the current account and vice versa. However, the Mundell-Fleming model mainly focuses on the flow of tradable good. Exchange rates under the Mundell-Fleming framework only act as the insulator to the domestic economy from its export shocks. The Mundell-Fleming model was largely rejected by the recent float data (MacDonald and Taylor 1993). Walter (1991) reports that the majority of the foreign exchange market transactions are unrelated to current account flows. Therefore, a more appropriate exchange rate model should emphasis the role of the capital the account rather than the current account as the main driving force of the exchange rate.
In this study, we survey the literature on the modern fundamentals-based models of exchange rate determination; namely the monetary and the portfolio-balance approaches. Then, we review the empirical evidence for the models and examine the possible shortcomings of these models