Acclaimed for its clarity, Exchange Rates and International Finance provides an approachable guide to the causes and consequences of exchange rate fluctuations, enabling you to grasp the essentials of the theory and its relevance to these major events in currency markets.



The orientation of the book remains towards exchange rate determination, with particular emphasis given to the contributions of modern finance theory.



This sixth edition of this established text addresses the impact of the global financial crisis.
New to this Edition

New to this edition
New chapter on Scapegoat Models
Extended coverage on risk, global financial crisis, forecasting issues (Meese and Rogoff), factor models and the latest developments in the Eurozone
Chapters re-ordered to improve structure and flow of topics
Inclusion of FT articles and vignettes, illustrating real-world examples with accompanying questions
Learning outcomes
Updated reading guides
Improved PowerPoint slides and ‘bank of questions’ for lecturers

Table of Contents

Preface and acknowledgements

1 Introduction

Introduction

1.1 What is an exchange rate?

1.2 The market for foreign currency

1.3 The balance of payments

1.4 The DIY model

1.5 Exchange rates since World War II: a brief history

1.6 Overview of the book

Summary

Reading guide

Notes

Part 1

THE INTERNATIONAL SETTING

2 Prices in the open economy: purchasing power parity

Introduction

2.1 The law of one price in the domestic economy

2.2 The law of one price in the open economy

2.3 A digression on price indices

2.4 Purchasing power parity

2.5 Purchasing power parity – the facts at a glance

2.6 Purchasing power parity extensions

2.7 Empirical research

2.8 Conclusions

Summary

Reading guide

Notes



3 Financial markets in the open economy

Introduction

3.1 Uncovered interest rate parity

3.2 Covered interest rate parity

3.3 Borrowing and lending

3.4 Covered interest rate parity – the facts

3.5 Efficient markets – a first encounter

3.6 The carry trade paradox

3.7 Purchasing power parity revisited

Summary

Reading guide

Notes

4 Open economy macroeconomics

Introduction

4.1 IS–LM model of aggregate demand

4.2 Aggregate supply

4.3 Conclusions

Summary

Reading guide

Notes

Part 2

EXCHANGE RATE DETERMINATION

5 Flexible prices: the monetary model

Introduction

5.1 The simple monetary model of a floating exchange rate

5.2 The simple monetary model of a fixed exchange rate

5.3 Interest rates in the monetary model

5.4 The monetary model as an explanation of the facts

5.5 Conclusions

Summary

Reading guide

Notes



6 Fixed prices: the Mundell–Fleming model

Introduction

6.1 Setting

6.2 Equilibrium

6.3 Monetary expansion with a floating exchange rate

6.4 Fiscal expansion with a floating exchange rate

6.5 Monetary expansion with a fixed exchange rate

6.6 Fiscal expansion with a fixed exchange rate

6.7 The monetary model and the Mundell–Fleming model compared

6.8 Evidence

6.9 Conclusions

Summary

Reading guide

Notes

7 Sticky prices: the Dornbusch model

Introduction

7.1 Outline of the model

7.2 Monetary expansion

7.3 A formal explanation

7.4 Case study: oil and the UK economy

7.5 Empirical tests: the Frankel model

7.6 Conclusions

Summary

Reading guide

Notes

8 Portfolio balance and the current account

Introduction

8.1 Specification of asset markets

8.2 Short-run equilibrium

8.3 Long-run and current account equilibrium

8.4 Evidence on portfolio balance models

8.5 Conclusions

Summary

Reading guide

Notes

9 Currency substitution

Introduction

9.1 The model

9.2 Evidence on currency substitution

9.3 Conclusions

Summary

Reading guide

Notes

10 General equilibrium models

Introduction

10.1 The Redux model

10.2 Extensions of Redux

10.3 Evidence

10.4 Conclusions

Summary

Reading guide

Notes

Appendix 10.1: Derivation of price index (Equation 10.2)

Appendix 10.2: Derivation of household demand (Equations 10.6 and 10.6′)

Appendix 10.3: Log linearisation of model solution (Equations L1–L4)

Appendix 10.4: Sticky prices

Part 3

A WORLD OF UNCERTAINTY

11 Market efficiency and rational expectations

Introduction

11.1 Mathematical expected value

11.2 Rational expectations

11.3 Market efficiency

11.4 Unbiasedness

11.5 The random walk model

11.6 Testing for efficiency: some basic problems

11.7 Spot and forward rates: background facts

11.8 Results

11.9 Conclusions

Summary

Reading guide

Notes

12 The ‘news’ model, exchange rate volatility and forecasting

Introduction

12.1 The ‘news’ model: a simple example

12.2 The monetary model revisited

12.3 Testing the ‘news’

12.4 Results

12.5 Volatility tests, bubbles and the peso problem

12.6 Conclusions

Summary

Reading guide

Notes

13 The risk premium

Introduction

13.1 Assumptions

13.2 A simple model of the risk premium: mean–variance analysis

13.3 A general model of the risk premium

13.4 The evidence on the risk premium

13.5 Conclusions

Summary

Reading guide

Notes

Part 4

FIXED EXCHANGE RATES

14 Target zones

Introduction

14.1 What is a target zone

14.2 Effect of target zones

14.3 Smooth pasting

14.4 An option interpretation

14.5 A honey moon for policymakers?

14.6 Beauty and the beast: the target zone model meets the facts

14.7 Intramarginal interventions: leaning against the wind

14.8 Credibility and realignment prospects

14.9 Conclusions

Summary

Reading guide

Notes

Appendix 14.1: Formal derivation model

15 Crises and credibility

Introduction

15.1 First-generation model

15.2 Second-generation crisis models

15.3 Third-generation models

15.4 The 2008 crisis

15.5 Conclusions

Summary

Reading guide

Notes

16 Optimum currency areas, monetary union and the eurozone

Introduction

16.1 Benefits of monetary union

16.2 Costs of monetary union

16.3 Other considerations

16.4 Currency bonds

16.5 The eurozone

16.6 Conclusions

Summary

Reading guide

Notes

Part 5

ALTERNATIVE PARADIGMS

17 Heterogeneous expectations and scapegoat models

Introduction

17.1 The market maker model

17.2 Introduction to expectations with heterogeneous information

17.3 Conclusions

Summary

Reading guide

Notes