Expected and Unexpected Changes in Exchange Rates: The Roles of Relative Price Levels, Balance-of-Payments Factors, Interest Rates and Risk

Abstract

One of the central unresolved questions about exchange rate determination is how to fit balance-of-payemnts flows and risk factors into a rational expectations version of the asset equilibrium model. In addressing that question, this paper begins with the view that observerd changes in exchange rates predominantly reflect revisions in expectations in response to surprising new information and distinguishes in Section 1 between different types of revisions in the term structure of exchange rate expectations. Wealth variables and exchange risk are recognized to play important roles in portfolio decisions, and Section 2 describes how this provides a place for current-account flows in asset equilibrium models of exchange rate determination. Section 3 discusses the role and limitiations of rational expectations assumptions in tying down the level of the therm sutrcture of exchange rate expectations.