An Alternative Theory of Long-Run Exchange Rate Determination

Conventional exchange rate models are based on thefundamental hypothesis that in the long run realexchange rates adjust in such a way as to makecountries equally competitive eliminating tradesurpluses and deficits. The contention of this bookbased on the theoretical underpinnings of absolutecompetitive advantage is that movements of long-runexchange rate are determined by real unit costs oftradable goods. According to this argument theempirical finding of persistent trade imbalances isnot the exception but rather an anticipated outcome.When competitive absolute advantage replaces the alltoo often embraced principle of comparativeadvantage a framework emerges that stands inopposition to orthodox models. A theoreticallygrounded empirically robust explanation of realexchange rate movements is constructed that can be ofpractical use to researchers but also and equallyimportantly to policymakers.