Important Concepts

Asset market approach                  Explains exchange rates in terms of demands andsupplies
to exchange rates:                          of all assetsdenominated in different currencies. The monetary
                                                     approachto exchange rates is a variant of this approach in which 
                                                     onlydemands and supplies of the money asset are considered.

Bandwagon:                                   A situation inwhich investors expect the recent trend in exchange rates to extend into thefuture.

Law of one price:                           Asserts that a single commodity will havethe same price everywhere once the prices are expressed in the samecurrency.  This is another way of statingthe purchasing power parity hypothesis. It seems to be true chiefly forcommodities that are standardized and heavily traded internationally.

Monetaryapproach                       Seeks to explainexchange rates by focusing on the demands
to exchange rates:                          for and suppliesof national monies.

Nominal bilateral exchange rate:   The exchange rate we see quoted in foreign exchange markets.

Nominal effective exchange rate:   The weighted-average exchange value of a country’s currency,where the weights reflect the importance of theother countries in  the home country’stotal international trade.

Overshooting:                                When the exchangerate is driven past its ultimate equilibrium rate (usually thought to be thePPP level), and then back to that rate later, during the adjustment of themacroeconomy to an exogenous shock. This effect is the consequence of goodsprices that are sticky in the short run.

Purchasing power parity:              In its absolute form, this hypothesis says that the exchange rate will equal theratio of the domestic price level to the foreign price level, or e = P/P_f. (In its relativeform, the hypothesis states that the difference over time in inflation rateswill be offset by changes in the exchange rate over that period)] Anapproximation of relative purchasing power parity is [e_future – e_today]= [(inflationrate at home) minus (inflation rate in the foreign country]).

Quantitytheory                             Theorizesthat, in any country, the money supply is equal to the
of money:                                       demand for money,which is directly proportional to the value of
                                                     nominalgross domestic product. This is symbolized as M = kPY.
                                                     Here,money’s only role is as a medium of exchange.

Real exchange rate:                       A way of measuring the price of foreign goods,not just in currency-adjusted terms, but also in price-level-adjusted terms.The real exchange rate on a currency at any moment in time is calculated as:[(foreign cost of home currency) x (P/P_f) x (100)].  If purchasing power parity holds between thetwo countries, the real exchange rate will be 100. When the real exchange rateis above 100, the home currency is overvalued and the foreign currency isundervalued; when the real exchange rate is less than 100, the home currency isundervalued and the foreign currency is overvalued.

Speculative bubble:                       A self‑confirmingupward or downward movement in a price (here, the exchange rate) that is out ofline with the changes in the fundamental factors that determine the price ofthat object.