This study analyzes the determination of the exchange rate system in a small economy when external real and monetary disturbances occur. Choice of exchange rate policy is investigated using a model assuming rational expectations and a loss function expressing the squared deviations of the small country output from desired output. The distinguishing feature of the analysis is the emphasis on real as well as monetary disturbances which originate abroad but are a source of domestic output variation. the link between foreign monetary and real disturbances and variance in output is traced using the thoretical model and the loss function assumed. The emphasis of the analysis is on a three country (one small and two large) trading situation, whereby the small country trades with two major large country trading partners. It is assumed throughout that there is perfect commodity arbitrage between two large countries. The small country imports an intermediate good from one of the large countries and exports a finished good. The small country doesnot import goods for consumption. there is perfect capital movement between two large countries, but capital is immobile between the small and these two large countries. The analysis indicates that occurrence of purely nominal shocks abroad are not transmitted to the small country under floating exchange rate system. The presence of real disturbances in large countries induce lower prices for the goods they produce, but the effect on the exchange rate is ambiguos. This study concludes that in general the adoption of a flexible exchange rate system by a small country is preferred and results in lower loss in most cases of external disturbance.

With the shift to a system of floating exchange rates among major currencies in 1973, there was a shift of emphasis from the external balance to the exchange rate determination. Attempts have been made to explain the behavior of the exchange rate both theoretically and empirically over the last 20 years. Most models could not explain what happened, as in the 1980s, when the exchange rate moved a lot. Alternative models based on different approaches give different explanations and suggest different policies. This study examines the implications of the models to see what light the empirical results shed on the issues. Results of this study indicate that both monetary and real factors are important in explaining the behavior of the exchange rate, but the results generally support the view of the monetary approach.