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CHAPTER 19 WHAT DETERMINES EXCHANGE RATES? Objectives of the Chapter In the short run, fluctuations in exchange rates can be related to demands for and supplies of assets denominated in different currencies—what we call “the asset market approach to exchange rates.” Here, we revisit the international financial investors and incorporate the impact of interest rate differentials and exchange rate expectations into the determination of the current spot exchange rate. In the long run, purchasing power parity suggests that movements in exchange rates are determined by differences in countries’ inflation rates. The “monetary approach to exchange rates” explains inflation rates as functions of relative demands for and supplies of domestic and foreign monies. Linking the two, we get a model that ties exchange rates to “fundamentals” such as incomes and relative money supplies. After studying Chapter 19 you should be able to explain 1. the impact of interest rates on the current exchange rate. 2. the impact of expectations about future spot rates on the current exchange rate. 3. what exchange rate overshooting is, and why it can occur. 4. how short-run exchange rate movements can diverge from what would be predicted by market fundamentals. 5. the purchasing power parity hypothesis, in both its absolute and relative forms. 6. the quantity theory of money in a two-country world. 7. the difference between nominal and real exchange rates. Important Concepts Asset market approach Explains exchange rates in terms of demands and supplies to exchange rates: of all assets denominated in different currencies. The monetary approach to exchange rates is a variant of this approach in which only demands and supplies of the money asset are considered. Bandwagon: A situation in which investors expect the recent trend in exchange rates to extend into the future. Law of one price: Asserts that a single commodity will have the same price everywhere once the prices are expressed in the same currency. This is another way of stating the purchasing power parity hypothesis. It seems to be true chiefly for commodities that are standardized and heavily traded internationally. Monetary approach Seeks to explain exchange rates by focusing on the demands to exchange rates: for and supplies of national monies. Nominal bilateral exchange rate: The exchange rate we see quoted in foreign exchange markets. Nominal effective exchange rate:
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This note was uploaded on 02/18/2010 for the course ECON 343 taught by Professor Dblack during the Fall '09 term at University of Delaware.

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