KEY POINTS

1. Our theory of exchange rates builds on two ideas: arbitrage and expectations. First, we developed the theory for the case of floating exchange rates.
2. In the short run, we assume prices are sticky and the asset approach to exchange rates is valid. Interest-bearing accounts in different currencies may offer different rates of nominal interest. Currencies may be expected to depreciate or appreciate against one another. There is an incentive for arbitrage: investors will shift funds from one country to another until the expected rate of return (measured in a common currency) is equalized. Arbitrage in the foreign exchange (forex, or FX) market determines today’s spot exchange rate, and the forex market is in equilibrium when the uncovered interest parity condition holds. To apply the uncovered interest parity (UIP) condition, however, we need a forecast of the expected exchange rate in the long run.
3. In the long run, we assume prices are flexible and the monetary approach to exchange rates is valid. This approach states that in the long run, purchasing power parity (PPP) holds so that the exchange rate must equal the ratio of the price levels in the two countries. Each price level, in turn, depends on the ratio of money supply to money demand in each country. The monetary approach can be used to forecast the long-run future expected exchange rate, which, in turn, feeds back into short-run exchange rate determination via the UIP equation.
4. Putting together all of these ingredients yields a complete theory of how exchange rates are determined in the short run and the long run.
5. This model can be used to analyze the impact of changes to monetary policy, as well as other shocks to the economy.
6. A temporary home monetary expansion causes home interest rates to fall and the home exchange rate to depreciate. This temporary policy can be consistent with a nominal anchor in the long run.
7. A permanent home monetary expansion causes home interest rates to fall and the home exchange rate to depreciate and, in the short run, overshoot what will eventually be its long-run level. This permanent policy is inconsistent with a nominal anchor in the long run.
8. The case of fixed exchange rates can also be studied using this theory. Under capital mobility, interest parity becomes very simple. In this case, the home interest rate equals the foreign interest rate. Home monetary policy loses all autonomy compared with the floating case. The only way to recover it is to impose capital controls. This is the essence of the trilemma.