Chapter 18
The Foreign Exchange Market
Chapter 18 explains behavior in the foreign exchange market by using a modern asset-market
approach to exchange rate determination. This asset-market approach is now the dominant
method of analyzing exchange rate movements in the literature, and it has major advantages over
the more conventional treatment of the foreign exchange market typically found in money and
banking textbooks.
The asset-market approach is developed in several steps. First, the long-run determinants of the
exchange rate are laid out, and then the information about the long-run determinants is embedded
in a model of the short-run determination of exchange rates. The key idea that must be
transmitted to the student is that the demand for domestic currency (say dollar) assets is
determined by the relative expected return on these assets.
The four applications in the chapter on the Economist’s Big Mac Index and PPP, on the response
of exchange rates to changes in interest rates, the effect of global financial crisis on the dollar,
and the impact of Britain’s exit (Brexit) and the subsequent collapse of the pound, can all be used
in class to show students that the material they have learned has practical uses.