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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 Appendix 17.1 : A. Derivation of the first-order condition for money (Equation 17.36) B. Derivation of the first-order condition for foreign bonds (Equation 17.37) C. Proof of the solution for the exchange rate (Equation 17.43) D. Proof that Equation 17.50 is the solution for Equation 17.49 18 Order flow analysis Introduction 18.1 The structure of the foreign currency market 18.2 Defining order flow 18.3 Fear of arbitrage, common knowledge and the hot potato 18.4 The pricing process 18.5 Empirical studies of order flow 18.6 Conclusions Summary Reading guide Notes 19 A certain uncertainty: nonlinearity, cycles and chaos Introduction 19.1 Deterministic versus stochastic models 19.2 A simple nonlinear model 19.3 Time path of the exchange rate 19.4 Chaos 19.5 Evidence 19.6 Conclusions Summary Reading guide Notes Part 6 CONCLUSIONS 20 Conclusions Introduction 20.1 Summary of the book 20.2 The research agenda Notes Appendix: list of symbols Bibliography Index

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