Objectives of the Chapter

In the short run,fluctuations in exchange rates can be related to demands for and supplies ofassets denominated in different currencies—what we call “the asset marketapproach to exchange rates.” Here, we revisit the international financialinvestors and incorporate the impact of interest rate differentials andexchange rate expectations into the determination of the current spot exchangerate.

In the long run,purchasing power parity suggests that movements in exchange rates aredetermined by differences in countries’ inflation rates. The “monetary approachto exchange rates” explains inflation rates as functions of relative demandsfor and supplies of domestic and foreign monies. Linking the two, we get amodel that ties exchange rates to “fundamentals” such as incomes and relativemoney supplies.

After studyingChapter 19 you should be able to explain

     1.    the impact ofinterest rates on the current exchange rate.

     2.    the impact ofexpectations about future spot rates on the current exchange rate.

     3.    what exchangerate overshooting is, and why it can occur.

     4.    how short‑runexchange rate movements can diverge from what would be predicted by marketfundamentals.

     5.    the purchasingpower parity hypothesis, in both its absolute and relative forms.

     6.    the quantitytheory of money in a two-country world.

     7.    the differencebetween nominal and real exchange rates.