Vol.7, No.2 / August 1989

Exchange Rate Fluctuations, Balance of Payments Imbalances and Internationalization of Financial Markets

Mitsuhiro Fukao

This paper tries to explain large exchange rate swings and persistent balance of payments imbalances among major countries in the 1980s. With a simple two-country model, we illustrate that the behavior of the real exchange rate and the current account depends importantly on the degree of internationalization of financial markets. As internationalization progresses, an expansionary fiscal policy in one country induces a larger appreciation of its currency and a larger and more persistent current account imbalance. In order to test our theory, we estimated regression equations of yen-dollar and DM-dollar exchange rates using a Kalman filter method, taking account of the structural shifts in the foreign exchange market due to internationalization.

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