Rational Expectations, Uncertainty and Exchange Rate Determination

The theory of exchange rate determination has evolved considerably in recent years. Starting from a supposition that exchange rates were determined by Balance of Trade equilibrium, and hence-reflected "real" factors, the resurgence of the Monetary Theory has caused a sharp change in perceptions as to how exchange rates are determined. The Monetary Approach to the Balance of Payments focused attention upon the role of currencies as assets and hence viewed the exchange rate as a relative price of two assets. Thus, those factors that, determine the demand for each currency - as well as the supply - are seen to explain exchange rates. Since, in the context of the Monetary Approach the demands for currencies are generally transactions demands, and since transaction demands for each currency are generally assumed proportional to nominal domestic output (with, perhaps, the rate of interest also affecting transactions demand), the general conclusion emerges that the exchange rate between two currencies will depend upon the ratio of domestic output levels, as well as the ratio of currency supplies.