Exchange rates are relative prices of national currencies, and under a floating rate regime they may naturally be viewed as being determined by the interplay of supply and demand in foreign exchange markets. This proposition is uncontroversial, but it provides no more than a starting point for understanding exchange rate determination and its relationship to other macroeconomic variables and to policy. Supply and demand in currency markets are dependent on conditions in other markets, real and financial, which are affected in turn by exchange rates themselves. In fact any analysis which attempted to be general would describe exchange rates as being determined in a complex process of interaction simultaneously with all other variables in the international macro-economy. Such an approach would prove too cumbersome to be helpful empirically. Simplifying assumptions have therefore been used in most standard models to provide explanations which are in varying degrees partial. Each model ...
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