Abstract
Publisher Summary This chapter discusses the formation of short-run and long-run exchange rate expectations. It describes the construction and analysis of a dynamic model of exchange rate determination that allows for errors in predictions of both short and long-run exchange rates. The model is used to investigate the consequences of a non-neutral disturbance such as an exogenous shift in world interest rates. It is seen that the two-stage expectational hypothesis has the implication that both the instantaneous and dynamic behavior of the exchange rate is dramatically different from that which would emerge from a straightforward application of the Dornbusch model. An essential ingredient of this model, however, is the unstated assumption that the equilibrium exchange rate is correctly and instantaneously known to domestic speculators. It should be evident that the correct computation of the long-run exchange rate and price levels is considerably more complex in the face of such disturbances than with a pure monetary disturbance, and requires knowledge of the structural parameters δ, λ, and σ in addition to precise information as to the working of the model.
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