1. Exchange rates play an important role in the macroeconomy.
2. This chapter has explained what exchanges are and how they behave under fixed and flexible rates.
3. It described the players in the FX market, including traders and the government. The government affects the FX market by using capital controls and by intervening to achieve a peg.
4. What determines exchange rates? CIP and UIP are arbitrage conditions that suggest how interest rates and expected future spot rates can influence current spot rates.
The forex market has a long and often tumultuous record and, in today’s globalized world, exchange rates matter more than ever. They affect the prices of international transactions, can be a focus of government policy, and often play a major role in economic and political crises.
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This chapter has set the stage for our study of exchange rates. We learned what exchange rates are and how they are used. We have also seen how they have behaved in reality under different exchange rate regimes. History shows a vast range of past experiences, and this experimentation continues.
These observations underscore the importance of understanding different regimes and their causes and consequences. We have prepared ourselves by examining the workings of the forex market in some detail. Government intervention (or its absence) in this market determines the nature of the exchange rate regime in operation, from fixed to floating. The workings of actors in the forex market then ultimately determine equilibrium values of exchange rates.
How is forex market equilibrium determined? We can now see that two key forces operate in the forex market: arbitrage and expectations. Through expectations, news about the future can affect expected returns. Through arbitrage, differences in expected returns are equalized, as summed up by the two important interest parity conditions, covered interest parity and uncovered interest parity. In the next two chapters, we build on these ideas to develop a complete theory of exchange rates.
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