International Macroeconomics

- Chapter 4: Exchange Rates II: The Asset Approach

in the Short Run

Dr. Yvonne Sperlich,

University of Geneva
Spring semester 2020

Slides based on Feenstra/Taylor, 2015

1
 Content of chapter

1. Exchange Rates and Interest Rate in Short Run: UIP

and FX Market Equilibrium
2. Interest Rates in the Short Run: Money Market
Equilibrium
3. The Asset Approach: Applications and Evidence
4. A Complete Theory: Unifying the Monetary and Asset
Approaches
5. Fixed Exchange Rates and the Trilemma
6. Conclusions

Slides based on Feenstra / Taylor

1
Introduction

• Deviations from purchasing power parity (PPP) occur in the

short run: the same basket of goods generally does not cost
the same everywhere at all times.

• Short-run failures of the monetary approach prompted

economists to develop an alternative theory to explain
exchange rates in the short run: the asset approach to
exchange rates.

• The asset approach is based on the idea that currencies are

assets.

• The price of the asset in this case is the spot exchange rate,
the price of one unit of foreign exchange. 3
1 Exchange Rates and Interest Rates in the Short Run:
UIP and FX Market Equilibrium

Risky Arbitrage
The uncovered interest parity (UIP) equation is the
fundamental equation of the asset approach to exchange
rates.

(4-1)

4
Building Block: Uncovered Interest Parity—The Fundamental Equation of the Asset
Approach In this model, the nominal interest rate and expected future exchange rate
are treated as known exogenous variables (in green). The model uses these variables
to predict the unknown endogenous variable (in red), the current spot exchange rate.

5
Ex.:
Current European interest rate 3%,
current US interest rate 5%,

Suppose that we made a forecast (using long-run monetary

model of exchange rates) so that the expected future exchage
rate is 1.224 dollar per euro.

6
Equilibrium in the FX Market: An Example

The foreign exchange (FX) market is in equilibrium when the domestic

and foreign returns are equal. In this example, the dollar interest rate is
5%, the euro interest rate is 3%, and the expected future exchange rate
(one year ahead) is = 1.224 $/€. The equilibrium is highlighted in bold
type.

7
Equilibrium in the FX Market: An Example

The foreign exchange

market is in
equilibrium at point 1,
where the domestic
returns DR and
expected foreign
returns FR are equal at
5% and the spot
exchange rate is 1.20
$/€.

8
Changes in Domestic and Foreign Returns and
FX Market Equilibrium

To gain greater familiarity with the model, let’s see how the FX
market responds to three separate shocks:

• A higher domestic interest rate, i$ = 7%

• A lower foreign interest rate, i€ = 1%

• A lower expected future exchange rate, Ee$/€ = 1.20 $/€

9
Changes in Domestic and Foreign Returns and FX Market Equilibrium
A Change in the Domestic Interest Rate

(a) A Change in the Home

Interest Rate A rise in the
dollar interest rate from 5% to
7% increases domestic
returns, shifting the DR curve
up from DR1 to DR2.
At the initial equilibrium
exchange rate of 1.20 $/€ on
DR2, domestic returns are
above foreign returns at point
4. Dollar deposits are more
attractive and the dollar
appreciates from 1.20 $/€ to
1.177 $/€. The new
equilibrium is at point 5.

10
Changes in Domestic and Foreign Returns and FX Market Equilibrium
A Change in the Foreign Interest Rate

(b) A Change in the Foreign

Interest Rate A fall in the euro
interest rate from 3% to 1%
lowers foreign expected dollar
returns, shifting the FR curve
down from FR1 to FR2. At the
initial equilibrium exchange
rate of 1.20 $/€ on FR2,
foreign returns are below
domestic returns at point 6.
Dollar deposits are more
attractive and the dollar
appreciates from 1.20 $/€ to
1.177 $/€. The new
equilibrium is at point 7.

11
 A Change in the Expected Future Exchange Rate

A fall in the expected future exchange rate from 1.224 to 1.20 lowers foreign
expected dollar returns, shifting the FR curve down from FR1 to FR2. At the
initial equilibrium exchange rate of 1.20 $/€ on FR2, foreign returns are below 12
domestic returns at point 6. Dollar deposits are more attractive and the dollar
appreciates from 1.20 $/€ to 1.177 $/€. The new equilibrium is at point 7.
2 Interest Rates in the Short Run: Money Market Equilibrium

Money Market Equilibrium in the Short Run: How Nominal

Interest Rates Are Determined
The Assumptions
Two countries (US and EU); MD=MS; money supply controlled by
central banks
In this chapter, we make short-run assumptions that are quite
different from the long-run assumptions:
—

• In the short run, the price level is sticky; fixed at P

• In the short run, the nominal interest rate i is fully flexible
and adjusts to bring the money market to equilibrium.

The assumption of sticky prices, also called nominal rigidity, is

common to the study of macroeconomics in the short run. 13
Why do we make the different assumptions in short run?

14
 Money Market Equilibrium in the Short Run: How
Nominal Interest Rates Are Determined
The Model
The expressions for money market equilibrium in the two
countries are as follows:
M US
 L(i$ ) YUS (4-2)
PUS
U.S. demand for
U.S. supply of real money balances
real money balances

M EUR (4-3)
 L(i )  YEUR
PEUR 
  European demand for
European supplyof real money balances 15
real money balances
Money Market Equilibrium in the Short Run:
Graphical Solution

The supply and demand

for real money balances
determine the nominal
interest rate.
The money demand curve
(MD) is downward-
sloping because an
increase in the interest
rate raises the cost of
holding money.

16
Money Market Equilibrium in the Short Run:
Graphical Solution

At points 2 and 3,
demand does not equal
supply and the interest
rate will adjust until the
money market returns
to equilibrium.

17
Another Building Block: Short-Run Money Market Equilibrium

Building Block: The Money Market Equilibrium in the Short Run In these
models, the money supply and real income are known exogenous variables
(in green boxes).
The models use these variables to predict the unknown endogenous
variables (in red boxes), the nominal interest rates in each country.
18
Changes in Money Supply and the Nominal Interest Rate

In panel (a), with a fixed price level P1US, an increase in nominal money supply from
M1US to M2US causes an increase in real money supply from M1US/P1US to M2US/P1US.
The nominal interest rate falls from i1$ to i2$ to restore equilibrium at point 2.

19
Changes in Money Supply and the Nominal Interest Rate

In panel (b), with a fixed price level P1US, an increase in real income from Y1US to Y2US
causes real money demand to increase from MD1 to MD2. 20
To restore equilibrium at point 2, the interest rate rises from i1$ to i2$.
 APPLICATION
Can Central Banks Always Control the Interest Rate? A Lesson
from the Crisis of 2008-2009

• In the United States, the Federal Reserve sets as its policy

rate the interest rate that it charges banks for overnight
loans.

• In normal times, changes in this cost of short-term funds for

the banks are usually passed through into the market rates
the banks charge to borrowers as well as on interbank loans
between the banks themselves.

• This process is one of the most basic elements in the so-

called transmission mechanism through which the effects of
monetary policy are eventually felt in the real economy. 21
(1) Banks regarded other banks as potential risk factors =>
lent much less and when they charged much higher interest
rates to compensate higher risks.
=> although the Fed brought its policy rate all the way down
from 5.25% to almost 0% in 2007 and 2008, there was no
similar decrease in market rates.

(2) Problem arose once policy rates hit the zero lower bound
(ZLB). Central banks’ capacity to lower interest rate further
was exhausted. However, many central banks wanted to keep
applying downward pressure to market rates to calm financial
markets. The Fed’s response was a policy of quantitative
easing.
22
The Fed engaged in a number of extraordinary policy actions to
push more money out more quickly:

1. It expanded the range of credit securities it would accept

as collateral to include lower-grade, private-sector bonds.

2. It expanded the range of securities that it would buy

outright to include private-sector credit instruments such
as commercial papers and mortgage-backed securities.

3. It expanded the range of counterparties from which it

would buy securities to include some nonbank institutions
such as primary dealers and money market funds.

23
A broken transmission: the Fed’s extraordinary
interventions did little to change private credit market 24
interest rates in 2008-2009.
The Monetary Model: The Short Run Versus the Long Run
Consider that home central bank that previously kept the
money supply constant switches to an expansionary policy,
allowing the money supply to grow at a rate of 5%.

• If this expansion is expected to be permanent, the

predictions of the long-run monetary approach and Fisher
effect are clear. The Home interest rate rises in the long run.

• If this expansion is expected to be temporary, all else equal,

the immediate effect is an excess supply of real money
balances. The home interest rate will then fall in the short
run.
25
Link between money supply, interest rate and exchange rate

 Expanded money supply leads to weaker currency in long

and short run,
 In short run: low interest rates and weak currency go
together
 In long-run: high interest rate and weak currency

Intuition behind:
Short-run, we assume that the expectations have not changed
concerning future exchange rates, inflation etc

Long run, prices here flexible. Money growth, inflation and

expected depreciation can move.
26
3 The Asset Approach: Applications and Evidence
The Asset Approach to Exchange Rates: Graphical Solution
Equilibrium in the Money Market and the FX Market

The figure summarizes the equilibria in the two asset markets in one diagram. In panel
(a), in the home (U.S.) money market, the home nominal interest rate i1$ is determined
by the levels of real money supply MS and demand MD with equilibrium at point 1.

27
The Asset Approach to Exchange Rates: Graphical Solution
Equilibrium in the Money Market and the FX Market (continued)

In panel (b), in the dollar-euro FX market, the spot exchange rate E1$/€ is determined by
foreign and domestic expected returns, with equilibrium at point 1′. Arbitrage forces the
domestic and foreign returns in the FX market to be equal, a result that depends on capital
mobility.
28
Capital Mobility Is Crucial
Our assumption that DR equals FR depends on capital mobility. If
capital controls are imposed, there is no arbitrage and no reason
why DR has to equal FR.

Putting the Model to Work

With this graphical apparatus in place, it is relatively
straightforward to solve for the exchange rate given all the known
(exogenous) variables we have specified previously.

29
Short-Run Policy Analysis
Temporary Expansion of the Home Money Supply

In panel (a), in the Home money market, an increase in Home money supply from M1US to M2US
— —
causes an increase in real money supply from M 1US/P1US to M 2US/P1US.To keep real money demand
equal to real money supply, the interest rate falls from to i1$ to i2$, and the new money market
equilibrium is at point 2.

30
Short-Run Policy Analysis
Temporary Expansion of the Home Money Supply (continued)

In panel (b), in the FX market, to maintain the equality of domestic and foreign
expected returns, the exchange rate rises (the dollar depreciates) from E1$/€ to E2$/€,
and the new FX market equilibrium is at point 2′.

31
Short-Run Policy Analysis
Temporary Expansion of the Foreign Money Supply

In panel (a), there is no change in the Home money market. In panel (b), an
increase in the Foreign money supply causes the Foreign (euro) interest rate 32
to fall from i1€ to i2€.
Short-Run Policy Analysis
Temporary Expansion of the Foreign Money Supply (continued)

For a U.S. investor, this lowers the foreign return i€ + (Ee$/ € − E$/€)/E$/€, all else equal. To
maintain the equality of domestic and foreign returns in the FX market, the exchange
rate falls (the dollar appreciates) from E1$/€ to E2$/€, and the new FX market equilibrium 33
is at point 2′.
APPLICATION
The Rise and Fall of the Dollar, 1999-2004
U.S.–Eurozone Interest Rates and Exchange Rates, 1999-2004
From the euro’s birth in 1999 until
2001, the dollar steadily
appreciated against the euro, as
interest rates in the United States
were raised well above those in
Europe. In early 2001, however, the
Federal Reserve began a long series
of interest rate reductions. By 2002
the Fed Funds rate was well below
the ECB’s refinancing rate. Theory
predicts a dollar appreciation
(1999–2001) when U.S. interest
rates were relatively high, followed
by a dollar depreciation (2001–
2004) when U.S. interest rates were
relatively low. Looking at the figure,
you will see that this is what 34
occurred.
4 A Complete Theory: Unifying the Monetary and
Asset Approaches

For a complete theory of exchange rates:

• We need the asset approach (this chapter)—short-run money
market equilibrium and uncovered interest parity:

PUS  M US /[ LUS (i$ )YUS ] 


PEUR  M EUR /[ LEUR (i )YEUR ] The asset approach

E$e/ €  E$e/ € 
i$  i€ 
E$ / € 


35
• To forecast the future expected exchange rate, we also need
the long-run monetary approach from the previous chapter—a
long run monetary model and purchasing power parity:
e
PUS  M US
e
/[ LUS (i$e )YUS
e
] 

e
PEUR  M EUR /[ LEUR (i )YEUR ] The monetary approach
e e e (4-5)

E$e/ €  PUS
e e
/ PEUR 

• Combining the asset and monetary approach, we can see how

the two key mechanisms of expectations and arbitrage
determine exchange rates in both the short run and the long
run. 36
A Complete Theory of
Floating Exchange
Rates: All the Building
Blocks Together Inputs
to the model are
known exogenous
variables (in green
boxes). Outputs of the
model are unknown
endogenous variables
(in red boxes). The
levels of money
supply and real
income determine
exchange rates. 37
Confessions of a Forex Trader
In the world of exchange rate forecasting, three methodologies
are generally used:
1. Economic fundamentals

2. Politics

3. Technical methods

A recent survey of UK forex traders provided some interesting

insights into this world. One-third described their trading as
“technically based,” and one-third said their trades were
“fundamentals-based”; others were jobbing or trading for clients.
38
 Permanent Expansion of the Home Money Supply, Short-Run Impact

In panel (a), the home price level is fixed, but the supply of dollar balances increases
and real money supply shifts out. To restore equilibrium at point 2, the interest rate falls
from i1$ to i2$. In panel (b), in the FX market, the home interest rate falls, so the
domestic return decreases and DR shifts down. In addition, the permanent change in 39
the home money supply implies a permanent, long-run depreciation of the dollar.
 Permanent Expansion of the Home Money Supply, Short-Run Impact
(continued)

Hence, there is also a permanent rise in Ee$/€, which causes a permanent increase in the
foreign return i€ + (Ee$/€ − E$/€)/E$/€, all else equal; FR shifts up from FR1 to FR2. The
simultaneous fall in DR and rise in FR cause the home currency to depreciate steeply,
leading to a new equilibrium at point 2′ (and not at 3′, which would be the equilibrium 40
if the policy were temporary).
 Permanent Expansion of the Home Money Supply, Short-Run Impact
(continued)

Long-Run Adjustment: In panel (c), in the long run, prices are flexible, so the home price
level and the exchange rate both rise in proportion with the money supply. Prices rise to
P2US, and real money supply returns to its original level M1US/P1US.
The money market gradually shifts back to equilibrium at point 4 (the same as point 1). 41
 Permanent Expansion of the Home Money Supply, Short-Run Impact
(continued)

Long-Run Adjustment (continued): In panel (d), in the FX market, the domestic return DR,
which equals the home interest rate, gradually shifts back to its original level. The foreign
return curve FR does not move at all: there are no further changes in the Foreign interest
rate or in the future expected exchange rate. The FX market equilibrium shifts gradually to
point 4′. The exchange rate falls (and the dollar appreciates) from E2$/€ to E4$/€. Arrows in 42
both graphs show the path of gradual adjustment.
Overshooting
Responses to a Permanent Expansion of the Home Money Supply

In panel (a), there is a one-time permanent increase in home (U.S.) nominal money
supply at time T.
In panel (b), prices are sticky in the short run, so there is a short-run increase in the
real money supply and a fall in the home interest rate. 43
Overshooting
Responses to a Permanent Expansion of the Home Money Supply (continued)

In panel (c), in the long run, prices rise in the same proportion as the money supply.
In panel (d), in the short run, the exchange rate overshoots its long-run value (the
dollar depreciates by a large amount), but in the long run, the exchange rate will
have risen only in proportion to changes in money and prices. 44
Overshooting in Practice

Exchange Rates for

Major Currencies
Before and After 1973
Under the Bretton
Woods system of fixed
but adjustable dollar
pegs, exchange rates
were mostly stable
from 1950 until 1970.
The system was
declared officially dead
in 1973. From then on,
all of these currencies
have fluctuated
against the dollar.

45
5 Fixed Exchange Rates and the Trilemma
What Is a Fixed Exchange Rate Regime?
• Here we focus on the case of a fixed rate regime without
controls so that capital is mobile (capital controls) and
arbitrage is free to operate in the foreign exchange market.

• Central banks buying and selling foreign currency at a fixed

price, thus holding the market exchange rate at a fixed level
—
denoted E.

• We examine the implications of Denmark’s decision to peg its

—
currency, the krone, to the euro at a fixed rate: EDKr/€
• The Foreign country remains the Eurozone, and the Home
country is now Denmark.
46
What Is a Fixed Exchange Rate Regime?
• In the long run, fixing the exchange rate is one kind of nominal
anchor.

• Even if it allowed the krone to float but had some nominal

anchor, Denmark’s monetary policy would still be constrained
in the long run by its chosen nominal target.

• What we now show is that a country with a fixed exchange

rate faces monetary policy constraints not just in the long run
but also in the short run.

47
Pegging Sacrifices Monetary Policy Autonomy
in the Short Run: Example
The Danish central bank must set its interest rate equal to i€, the
rate set by the European Central Bank (ECB):
E e
 EDKr / €
iDKr  i€  DKr / €
i
EDKr / €

Equals zero
for a credible
fixed exchange rate

Denmark has lost control of its monetary policy: it cannot

independently change its interest rate under a peg.
M DEN  PDEN LDEN (iDKr )YDEN  PDEN LDEN (i€ )YDEN 48
Pegging Sacrifices Monetary Policy Autonomy
in the Short Run: Example
Our short-run theory still applies, but with a different chain of
causality.
• Under a float:
o The home monetary authorities pick the money supply M.

o In the short run, the choice of M determines the interest

rate i in the money market; in turn, via UIP, the level of i
determines the exchange rate E.

o The money supply is an input in the model (an exogenous

variable), and the exchange rate is an output of the model
(an endogenous variable). 49
Pegging Sacrifices Monetary Policy Autonomy
in the Short Run: Example
Our short-run theory still applies, but with a different chain of
causality.
• Under a fix, this logic is reversed:
o Home monetary authorities pick the fixed level of the exchange
rate E.

o In the short run, a fixed E pins down the home interest rate i via
UIP (forcing i =i*); in turn, the level of i determines the level of
the money supply M necessary to meet money demand.

o The exchange rate is an input in the model (an exogenous

variable), and the money supply is an output of the model (an
endogenous variable). 50
A Complete Theory of
Fixed Exchange Rates:
Same Building Blocks,
Different Known and
Unknown Variables
Unlike in Figure 4-11,
the home country is
now assumed to fix its
exchange rate with the
foreign country.
The levels of real
income and the fixed
exchange rate
determine the home
money supply levels,
given outcomes in the
foreign country.

51
Pegging Sacrifices Monetary Policy Autonomy
in the Long Run: Example
• The price level in Denmark is determined in the long run by
PPP. But if the exchange rate is pegged, we can write long-run
PPP for Denmark as:

PDEN  EDKr / € PEUR

• With the long-run nominal interest and price level outside of
Danish control, monetary policy autonomy is impossible. We
just substitute iDKr  i€ and PDEN  EDKr / € PEURinto Denmark’s
long-run money market equilibrium to obtain:
M DEN  PDEN LDEN (iDKr )YDEN  EDKr / € PEUR LDEN (i )YDEN 52
Pegging Sacrifices Monetary Policy Autonomy
in the Long Run: Example
Our long-run theory still applies, but with a different chain of
causality.
• Under a float:
o The home monetary authorities pick the money supply M.

o In the long run, the growth rate of M determines the

interest rate i via the Fisher effect and also the price level P;
in turn, via PPP, the level of P determines the exchange rate
E.

o The money supply is an input in the model (an exogenous

variable), and the exchange rate is an output of the model 53
(an endogenous variable).
Pegging Sacrifices Monetary Policy Autonomy
in the Long Run: Example
Our long-run theory still applies, but with a different chain of
causality.
• Under a fix, this logic is reversed:
o Home monetary authorities pick the exchange rate E.
o In the long run, the choice of E determines the price level P
via PPP, and also the interest rate i via UIP; these, in turn,
determine the necessary level of the money supply M.
o The exchange rate is an input in the model (an exogenous
variable), and the money supply is an output of the model
(an endogenous variable). 54
The Trilemma
Consider the following three equations and parallel statements
about desirable policy goals.
A fixed exchange rate
/ €  E DKr / €
1. e
EDKr
 0 • May be desired as a means to promote
EDKr / €
stability in trade and investment
• Represented here by zero expected
depreciation
International capital mobility
/ €  E DKr / €
2. e
EDKr
 0 • May be desired as a means to promote
EDKr / €
integration, efficiency, and risk sharing
• Represented here by uncovered interest 55
parity, which results from arbitrage
The Trilemma
Consider the following three equations and parallel statements
about desirable policy goals.
3. iDKr / €  i€ Monetary policy autonomy
• May be desired as a means to manage the
Home economy’s business cycle
• Represented here by the ability to set the
Home interest rate independently of the
foreign interest rate

56
The Trilemma
• Formulae 1, 2, and 3 show that it is a mathematical
impossibility as shown by the following statements:
o 1 and 2 imply not 3 (1 and 2 imply interest equality,
contradicting 3).
o 2 and 3 imply not 1 (2 and 3 imply an expected change
in E, contradicting 1).
o 3 and 1 imply not 2 (3 and 1 imply a difference between
domestic and foreign returns, contradicting 2).
• This result, known as the trilemma, is one of the most
important ideas in international macroeconomics.
57
The Trilemma

The Trilemma Each corner of the triangle represents a viable policy choice.
The labels on the two adjacent edges of the triangle are the goals that can
be attained; the label on the opposite edge is the goal that has to be
sacrificed.

58
Intermediate Regimes
• The lessons of the trilemma most clearly apply when the
policies are at the ends of a spectrum:
• a hard peg or a float,
• perfect capital mobility or immobility,
• complete autonomy or none at all.

• But sometimes a country may not be fully in one of the three

corners: the rigidity of the peg, the degree of capital mobility,
and the independence of monetary policy could be partial
rather than full.

59
 APPLICATION
The Trilemma in Europe
The Trilemma in Europe

The figure shows selected central banks’ base interest rates for the period 1994 to 2010 with
reference to the German mark and euro base rates.
In this period, the British made a policy choice to float against the German mark and (after 1999)
against the euro. This permitted monetary independence because interest rates set by the Bank of
60
England could diverge from those set in Frankfurt.
APPLICATION
The Trilemma in Europe
The Trilemma in Europe (continued)

No such independence in policy making was afforded by the Danish decision to peg the krone
first to the mark and then to the euro. Since 1999 the Danish interest rate has moved in line
with the ECB rate. Similar forces operated pre-1999 for other countries pegging to the mark,
such as the Netherlands and Austria. Until they joined the Eurozone in 1999, their interest 61
rates, like that of Denmark, closely tracked the German rate.
APPLICATION

News and the Foreign Exchange Market in Wartime

• War raises the risk that a currency may depreciate in value

rapidly in the future, possibly all the way to zero.

• Investors in the foreign exchange market are continually

updating their forecasts about a war’s possible outcomes.

• As a result, the path of an exchange rate during wartime

usually reveals a clear influence of the effects of news.

62
APPLICATION

Exchange Rates and News in

the U.S. Civil War The value of
the Confederate dollar
fluctuated against the U.S.
dollar and is shown on a
logarithmic scale.
Against the backdrop of a
steady trend, victories and
advances by the North (N)
were generally associated with
faster depreciation of the
Confederate currency, whereas
major Southern successes (S)
usually led to a stronger
Confederate currency.

63
APPLICATION
News and the Foreign Exchange Market in Wartime
The Iraq War, 2002-2003
• In 2003 Iraq was invaded by a U.S.-led coalition of forces
intent on overthrowing the regime of Saddam Hussein, and
the effects of war on currencies were again visible.

Courtesy of the Federal Reserve Bank of Richmond

Courtesy Neil Shafer

Courtesy Neil Shafer 64

Courtesy Neil Shafer
APPLICATION
Exchange Rates and News in the Iraq War

Regime change looked more likely from 2002 to 2003. When the U.S. invasion ended, the
difficult postwar transition began. Insurgencies and the failure to find Saddam Hussein 65
became a cause for concern.
APPLICATION
Exchange Rates and News in the Iraq War (continued)

The Swiss dinar, the currency used by the Kurds, initially appreciated against the U.S.
dollar and the Saddam dinar. With bad news for the Kurds, the Swiss dinar then
depreciated against the dollar until December 2003. 66
APPLICATION
News and the Foreign Exchange Market in Wartime
The Iraq War, 2002-2003
• What became of all these dinars? Iraqis fared better than the
holders of Confederate dollars.

• A new dinar was created under a currency reform announced

in July 2003 and implemented from October 15, 2003 to
January 15, 2004.

• Exchange rate expectations soon moved into line with the

increasingly credible official conversion rates and U.S. dollar
exchange rates for the new dinar.

67
Conclusions

• In this chapter, we drew together everything we have

learned so far about exchange rates.

• We built on the concepts of arbitrage and equilibrium in the

foreign exchange (FX) market in the short run, taking
expectations as given and applying uncovered interest parity.

• We also relied on the purchasing power parity theory as a

guide to exchange rate determination in the long run.

• Putting together all these building blocks provides a

complete and internally consistent theory of exchange rate
determination.
68