RDP 9501: Modern Approaches to Asset Price Formation: A Survey of Recent Theoretical Literature 5. Conclusion

A decade ago the Efficient Markets Hypothesis occupied a position of overwhelming dominance in the academic community. Speculative asset markets, including foreign currency markets, were viewed as being informationally efficient, with the conduct of rational investors and speculators ensuring that significant and sustained departures of asset prices from their fundamental values would not occur. The widespread intellectual allegiance accorded to the Efficient Markets paradigm no longer prevails. Its stature as the predominant model of asset market behaviour has been eroded not only by the actual behaviour of asset prices – including exchange rates in recent times – but also by the emergence of rigorous and cogent theoretical arguments challenging its central propositions. As a result, the academic community has undertaken a fundamental re-assessment of previously held views concerning not only the determinants of asset price movements, but also of the merits of certain policy instruments employed by governments and central monetary authorities.[38]

This paper has summarised some of the key propositions and arguments underlying an influential and rapidly growing body of new theoretical literature on asset price formation. The dynamics of the price formation process in speculative asset markets has always attracted considerable interest from academic economists. In recent years it has been an area of very active research, both theoretical as well as empirical; undoubtedly it will continue to be so in the years ahead as the profession refines and enhances its understanding of the dynamics of asset price formation.


Sterilised foreign exchange intervention is an example. Until recently, the view that there is a positive role for sterilised foreign exchange intervention did not have much support among academic economists, primarily due to their intellectual allegiance to the EMH, and in particular to Friedman's (1953) arguments concerning the stabilising influence of rational speculators. The theoretical literature surveyed in this paper however, demonstrates not only how and why an asset price such as the exchange rate, can deviate substantially from its “fundamental” value, but also sheds light on the circumstances and conditions in which official intervention in the foreign exchange market might be effective. A sample of theoretical contributions which advance a positive role for sterilised foreign exchange intervention are: De Long, Shliefer, Summers and Waldman (1990a), Dominguez and Frankel (1993), Hung (1991a, 1991b), Krugman (1989a, 1989b, 1991), Krugman and Miller (1992), and Miller, Weller and Williamson (1989). For discussion on the motivations underlying the Reserve Bank of Australia's intervention operations in recent years, see Macfarlane (1993). [38]