ABSTRACT
This chapter examines the nature of the cyclical relationship between the exchange rate and the terms of trade in a framework that incorporates the following characteristics: the exchange rate, the terms of trade and quantities are simultaneously determined in competitive equilibrium, domestic and foreign agents' current information on the division of disturbances into their real and monetary components is imperfect, and expectations of future variables are formed in a rational manner, i.e., they are optimal predictions conditional on current information. It discusses the nature of the solution for prices and deals with the inference problem solved by agents placed in a situation of incomplete current information concerning the monetary and real sources of price movements. The chapter concludes that real trade disturbances would lead to negatively correlated movements of the exchange rate and the terms of trade, so that an improvement in the home country's terms of trade would be accompanied by a lower price for foreign exchange.
