ABSTRACT
The model of exchange rate determination presented here combines elements of the “efficient market” and “monetary” approaches to asset markets. 1 The monetary aspects of the model arise through the assumption that the exchange rate, as the relative price of two monies, is primarily determined by the relative supplies and demands for these monies, and that the relevant demand and supply functions are stable functions of a small number of variables. 2 An “efficient market” is one in which all opportunities for profit are eliminated, implying, in the absence of transactions costs, that the law of one price will hold and that market price expectations will be unbiased predictors of actual future prices. 3 These principles are embodied in four important arbitrage conditions:
purchasing-power parity: the prices of commodities will always be the same when expressed in a common currency; 4
interest-rate parity: the real rate of return on assets will be equal and independent of the currency denomination of the asset;
the Fisher condition: the nominal rate of interest will be equal to the real rate of interest plus the expected rate of inflation; and
the rational expectations hypothesis: market price expectations will be equal to the actual predictions of the underlying theoretical model.
