Many barriers to the international movement of capital across national boundaries have been dismantled over the course of the last 20 years. Financial integration was greatly enhanced by the removal of capital controls on the part of the United States, Germany, Canada, Switzerland, and the Netherlands after 1973; the recycling of surpluses to developing countries through the Euromarkets in the 1970's; the removal of capital controls in the United Kingdom and Japan beginning in 1979; financial integration among European Community countries, including France and Italy, in preparation for 1992; recent moves toward financial liberalization in smaller countries in the Pacific; and the steady process of technical and institutional innovation that has proceeded around the world. Some popular tests of international capital mobility, however, appear to show anomalous results. Martin Feldstein and Charles Horioka upset conventional wisdom in 1980 when they concluded that changes in countries' rates of national saving had very large effects on their rates of investment and interpreted this finding as evidence of low capital mobility. The argument

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Much of the recent work on floating exchange rates goes under the name of the or view; the exchange rate is viewed as moving to equilibrate the international demand for stocks of assets, rather than the international demand for flows of goods as under the more traditional view. But within the asset view there are two very different approaches. These approaches have conflicting implications in particular for the relationship between the exchange rate and the interest rate. The first approach might be called the theory because it assumes that prices are perfectly flexible.' As a consequence of the flexible-price assumption, changes in the nominal interest rate reflect changes in the expected inflation rate. When the domestic interest rate rises relative to the foreign interest rate, it is because the domestic currency is expected to lose value through inflation and depreciation. Demand for the domestic currency falls relative to the foreign currency, which causes it to depreciate instantly. This is a rise in the exchange rate, defined as the price of foreign currency. Thus we get a positive relationship between the exchange rate and the nominal interest differential. The second approach might be called the theory because it assumes that prices are sticky, at least in the short run.2 As a consequence of the sticky-price assumption, changes in the nominal interest rate reflect changes in the tightness of monetary policy. When the domestic interest rate rises relative to the foreign rate it is because there has been a contraction in the domestic money supply relative to domestic money demand without a matching fall in prices. The higher interest rate at home than abroad attracts a capital inflow, which causes the domestic currency to appreciate instantly. Thus we get a negative relationship between the exchange rate and the nominal interest differential. The Chicago theory is a realistic description when variation in the inflation differential is large, as in the German hyperinflation of the 1920's to which Frenkel first applied it. The Keynesian theory is a realistic description when variation in the inflation differential is small, as in the Canadian float against the United States in the 1950's to which Mundell first applied it. The problem is to develop a model that is a realistic description when variation in the inflation differential is moderate, as it has been among the major industrialized countries in the 1970's. This paper develops a model which is a version of the asset view of the exchange rate, in that it emphasizes the role of expectations and rapid adjustment in capital markets. The innovation is that it combines the Keynesian assumption of sticky prices with the Chicago assumption that there are secular rates of inflation. It then turns out that the exchange rate is negatively related to the nominal interest differential, but positively related to the expected long-run inflation differential. The exchange rate differs from, or overshoots, its equilibrium value by an amount *Assistant professor, University of California-Berkeley. An earlier version of this paper was presented at the December 1977 meetings of the Econometric Society in New York. I would like to thank Rudiger Dornbusch, Stanley Fischer, Jerry Hausman, Dale Henderson, Franco Modigliani, and George Borts for comments. 'See papers by Jacob Frenkel and by John Bilson. 2The most elegant asset-view statement of the Keynesian approach is by Rudiger Dornbusch (1976c), to which the present paper owes much. Roots lie in J. Marcus Fleming and Robert Mundell (1964, 1968). They argued that if capital were perfectly mobile, a nonzero interest differential would attract a potentially infinite capital inflow, with a large effect on the exchange rate. More recently, Victor Argy and Michael Porter, Jiirg Niehans, Dornbusch (1976a,b,c), Michael Mussa (1976) and Pentti Kouri (1 976a,b) have introduced the role of expectations into the Mundell-Fleming framework.

Examining the correlation between trade and income cannot identify the direction of causation between the two. Countries' geographic characteristics, however, have important effects on trade, and are plausibly uncorrelated with other determinants of income. This paper therefore constructs measures of the geographic component of countries' trade, and uses those measures to obtain instrumental variables estimates of the effect of trade on income. The results provide no evidence that ordinary least-squares estimates overstate the effects of trade. Further, they suggest that trade has a quantitatively large and robust, though only moderately statistically significant, positive effect on income.

The overshooting theory of exchange rates seems ideally designed to explain some important aspects of the movement of the dollar in recent years. Over the period 1981-1984, for example, when real interest rates in the United States rose above those among trading partners (presumably due to shifts in the monetary/fiscal policy mix), the dollar appreciated strongly. It was the higher rates of return that made U.S. assets more attractive to international investors and caused the dollar to appreciate. The overshooting theory would say that, as of 1984 for example, the value of the dollar was so far above its long-run equilibrium that expectations of future depreciation were sufficient to offset the higher nominal interest rate in the minds of international investors. (Figure 1 shows the correlation of the real interest differential with the real value of the dollar, since exchange rates began to float in 1973.)

A common finding is that the forward discount is a biased predictor of future exchange rate changes. We use survey data on exchange rate expectations to decompose the bias into portions attributable to the risk premium and expectational errors. None of the bias in our sample reflects the risk premium. We also reject the claim that the risk premium is more variable than expected depreciation. Investors would do better if they reduced fractionally the magnitude of expected depreciation. This is the same result that many authors have found with forward market data, but now it cannot be attributed to risk.