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Cambridge Journal of Economics 28:205-227 (2004)
Cambridge Journal of Economics, Vol. 28, No. 2, © Cambridge Political Economy Society 2004; all rights reserved

Exchange rate indeterminacy in portfolio balance, Mundell–Fleming and uncovered interest rate parity models

Lance Taylor*

Address for correspondence: Lance Taylor, CEPA, 80 Fifth Avenue, 5th Floor, New York NY 10011, USA; email taylorl{at}newschool.edu

With full stock/flow accounting respected, the two-country open economy portfolio balance model has just two independent equations for asset market clearing. It can determine home and foreign interest rates but not the exchange rate. If asset market equilibria vary smoothly over time, the balance of payments equation in the Mundell–Fleming model is not independent and cannot set the exchange rate either. The familiar fixed reserves/‘floating rate’ vs endogenous reserves/‘fixed rate’ dichotomy does not exist, and ‘fundamentals-based’ econometric models of the exchange rate are bound to fail. An alternative is a two-country IS/LM model with exchange rate dynamics added. Its dynamic properties under uncovered interest rate parity are briefly explored.

Key Words: Exchange rate • Mundell–Fleming model

JEL classifications: F32, F41

Manuscript received July 9, 2001; final version received April 26, 2002.


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