This chapter discusses the dynamic behavior of exchange rates. It focuses on both the exchange rate's response to exogenous disturbances and the relation between exchange-rate movements and movements in such endogenous variables as nominal and relative prices, interest rates, output, and the current account. The chapter discusses an ideal treatment of exchange-rate dynamics by summarizing the relevant characteristics of the empirical record. All key features of the stochastic processes that appear to govern exchange rates and other statistically related economic variables have been reviewed in the chapter. It also presents a set of models that are compatible with at least some of the observed relationships. The chapter introduces market frictions so that the role of endogenous output fluctuations can be studied. The assumption of domestic price stickiness reinforces both the correlation between exchange-rate and terms-of-trade changes and the high short-run variability of the exchange rate compared to that of international price-level ratios. Finally, the chapter examines deterministic and stochastic models in which individual behavior is derived from an explicit intertemporal optimization problem.
