A Model of Exchange Rate Dynamics

Abstract

This model treats the exchange rate as an "asset price" that depends on expectations concerning exogenous real and monetary factors that will affect relative prices and absolute price levels in future periods. Changes in exchange rates reflect both expected changes in these exogenous factors and changes in expectations occasioned by new information. The model explains the random component in exchange rate behavior, the source of divergences from purchasing power parity, the anticipatory response of exchange rates to future expected disturbances, and the causes of exchange rate overshooting.