Exchange-Rate Dynamics

This paper discusses the dynamic behavior of exchange rates, focusing both on the exchange rate's response to exogenous shocks and the relation between exchange-rate movements and movements in important endogenous variables such as prices, interest rates, output, and the current account. Aspects of exchange-rate dynamics are studied in a variety of models, some of which are based on postulated supply and demand functions for assets and goods, and some of which are based on explicit individual utility-maximizing problems. Section 1 surveys the terrain. Section 2 explores the simplest model in which the relation among the exchange rate, price levels, and the terms of trade can be addressed -- a flexible-price small-country model in which wealth effects are absent and domestic and foreign goods are imperfect substitutes. Section 3 introduces market frictions so that the role of endogenous output fluctuations can be studied. Both sticky-price models and alternative market-friction models are discussed. Section 4 studies the link between the accumulation of foreign assets and domestic capital and the exchange rate.Section 5 examines deterministic and stochastic models in which individual behavior is derived from an explicit intertemporal optimization problem. Finally, section 6 offers concluding remarks.