Chapter 6: Exchange Rates6.1 IntroductionThe focus of this chapter is on exchange rate behavior. The chapter distinguishes betweentwo types of behavior, short run and long run. Short run behavior refers to day to day, week to week,or month to month movements in exchange rates. As we show below, market determined exchangerates tend to be very volatile in the short run, similar to the behavior of share prices we see in stockmarkets. The model that we present to explain this volatility is similar to models found in financethat try to explain the behavior of equity prices. A major component of the model is the notion thatexpectations about the future value of a currency play a role in setting today’s exchange rate.Long run exchange rate behavior refers to long term trends in the values of currencies. Themodel that we use to explain these trends is based on an idea known as purchasing power parity. This theory states that in the long run, exchange rates will tend to find levels that equalize pricesacross countries when measured in the same currency. 6.2 Exchange Rates in the Short RunFigure 6.1 provides graphs of month to month changes in the value of the Canadian dollar(C$), and Canadian stock prices between 1990 and 2003. Notice that for much of this period therewas considerable volatility in both of these series; the exchange rate fluctuated randomly as did thestock market. It was not uncommon for the C$ to gain or lose as much as 4% of its value during anygiven month. This type of volatility was not limited to the C$.The currencies of virtually all major1countries fluctuated with similar random gyrations over this period. See Figures 6.2 and 6.3 forgraphs of similar data series over the same time period. As the graphs show, volatility is commonNor was this period more volatile than any other recent experience. Indeed, asset price volatility, including1exchange rate changes has been especially high since the onset of the current recession.
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