12.1 Basic principles and preliminary remarks

  12.1.1 Foreign exchange market and nominal exchange rate
  12.1.2 Exchange rate policy
  12.1.3 Real exchange rate

Exchange rates are one of the most versatile and fascinating phenomena in economics. Everyone has heard about it or even experienced it on their vacations. But hardly anyone understands the reasons that drive the development of exchange rates. On the one hand, this has to do with the complexity and apparent contradiction of the various theories that look at exchange rates from different angles. It is quite possible that an event or a policy measure causes a short-term rise but a long-term fall in an exchange rate. It makes a big difference in forecasting whether one considers a macroeconomic model that has already aggregated individual decisions or a micro model that takes into account specifics of markets and models, for example, herd effects. If expectations are included in the calculation, the original result can even be reversed (see e.g. backloading), because today’s reaction to expected events based on current measures can even be stronger than the direct effect of this measure. Central banks can try to manipulate or fix exchange rates. In the context of exchange rate crises, sometimes huge events take place on the financial markets, which cannot be explained in terms of extent and speed with the classical models, but nevertheless have enormous effects on the economy and daily life.

In this online textbook, we will limit ourselves to the basic macroeconomic models. In addition to the elementary approaches of the theories of purchasing power parity and interest parity, these are the AADD model for the medium term, the monetary model and the Mundell Fleming model. General equilibrium models of a more modern kind (DSGE or CGE models) as well as models that specifically analyze crises are not dealt with.

(c) by Christian Bauer
Prof. Dr. Christian Bauer
Chair of monetary economics
Trier University
D-54296 Trier
Tel.: +49 (0)651/201-2743
E-mail: Bauer@uni-trier.de
URL: https://www.cbauer.de