With the collapse of the fixed exchange rate system established at Bretton Woods, the behavior of exchange rates changed dramatically. The demise of the fixed exchange rate system came at about the same time as the oil crisis, which meant that the substantial increase in exchange rate volatility was accompanied by high inflation. These changes in the economic environment led to a renewed interest in understanding movements in exchange rates and their effects on prices, wages, and employment. In this chapter, we survey different approaches to modeling exchange rates. In this survey, we limit our attention to the literature on exchange rate determination; the literature related to the other issues addressed in later chapters of the monograph is discussed in those chapters.

Our discussion starts with the early models of exchange rates, lists the weaknesses of each model from both a theoretical and an empirical perspective, and then progresses to the next, more sophisticated, model. In this presentation, rather than attempting to provide the minute details of each model in the literature, we focus on highlighting the essential features of each modeling approach and relating it to our work in the chapters to follow. In the next chapter, we describe the features of the model that we use for the analysis in this book and contrast this model with other models described in this chapter. Limitations of our model, and the extensions to it that might lead to interesting insights, are listed in Chapter 10.