Exchange rates

Abstract

The large movements in the price of the US dollar in terms of the German mark, the Japanese yen, the British pound, and various other currencies since the breakdown of the Bretton Woods system in the early 1970s again raises the question of how exchange rates are determined. This question tends to be dormant when the major countries peg their currencies – and then reappears when their currencies float. Approaches to explaining the movement of the exchange rate must recognize that the range of variation in the price of the US dollar in terms of the currencies of various other countries has been substantially larger than the contemporary change in the differential between the increase in the US price level and the increase in the price levels in these other countries. Moreover, deviations between market exchange rates and real (or price-level adjusted) exchange rates have been substantially larger with the floating exchange rate system than with the pegged exchange rate system of the 1950s and the 1960s. A second observation is that at times countries with strong and appreciating currencies have had large trade deficits (the United States in the early 1980s) and the countries with weak and depreciating currencies have had large trade surpluses (the United States in the late 1970s) – even though large trade deficits frequently are associated with weak or depreciating currencies, and large trade surpluses with strong or appreciating currencies. A third observation is that the range of variation in the price of the US dollar in terms of various foreign currencies does not appear to have declines during the first decade of experience with the floating exchange rate system. A fourth observation is that the differences in interest rates on comparable assets denominated in the US dollar and various foreign currencies have proven to be poor predictors of the rate of change of the price of the US dollar in terms of each of these currencies. Similarly, forward exchange rates have not proven to be effective predictors of future spot exchange rates at the maturity of the forward contracts.KeywordsExchange RateInflation RateTrade DeficitMarket Exchange RateExchange Rate SystemThese keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.