Menzie Chinn has done us all a service with his review of recent exchange rate theory, which I also skimmed in this. I was particularly intrigued by his reference to Frydman and Goldberg’s “Imperfect Knowledge Economics” approach. I read their article but not their book, and at the risk of thereby embarrassing myself offer these thoughts.
1. F&G are certainly right that a single model should not be expected to explain xrate movements over long periods of time because the market determinants are changing. This fits to a Kuhnian view: there are periods of “normal” trading, where movements respond predictably to economic news, and paradigm shifts—discontinuities in trading behavior.
2. PPP is a weak attractor at best. This is because the vast majority of transactions in international markets concern stocks, not flows. Forex markets are more like stamp or coin markets than markets in toothpaste, but PPP is based on the toothpaste template. Self-fulfilling prophecies can persist until the effects of currency misalignment are so disruptive that macro events force a correction; arbitrage doesn’t regulate. Any intermediate xrate would appear to be a statistical attractor due to mean reversion; is there any evidence that PPP outperforms other values in that respect?
3. F&G frame their argument in terms of forecasting, which on a practical level is certainly the test. The larger question, however, is whether their approach, or any of the alternatives, is consistent with the role assigned to xrates in micro models of international trade. This was the issue I raised in Challenge. The general answer, I still think, is that they don’t. F&G in particular present a view that, in theory, cannot be reconciled with strict comparative advantage. If a shifting bundle of macro fundamentals determine xrates, and if their weights change from one period to the next, how then can international prices be relied on to settle at levels that balance trade at the margin?
F&G end with the habitual sop toward trade orthodoxy, continuing the Hayekian tradition of deep insight into the process of markets combined with an inability or unwillingness to see that the normative view of markets has been eviscerated.