Looking For An Adequate Foreign Exchange Theory

The exchange rate is a hot international economic and political issue. Economists have designed their own theories to explain the mechanism of exchange rate determination. The purchasing power parity, interest rate parity, and the monetary approach to the exchange rate determination are three influential theories, the empirical study on them not only assess their validity, but also helps us to understand exchange rate mechanism better. Based on two data sets,1980 to 2010 the U.S. dollar against the Canadian dollar quarterly data, and 1999 to 2010 the British pound against the euro quarterly data, this paper tests above three theories and shows that:purchasing power parity, either absolutely or relative parity, performs well in practice; the practicability of interest rate parity is questionable; and the monetary approach is neither support nor questioned. Finally, this article summarizes factors that lead to these empirical test results, and pointed out what could be improved in terms of both the theory of exchange rate and empirical studies.