Exchange Rates, Prices and Interest Rates - Reconsidering the Basic Relationships of Exchange Rate Dynamics

The first part of this paper briefly summarizes the assumptions of economic theory on the relationships between exchange rates, prices and interest rates and the same time compares these assumptions with the empirical evidence. The fact that there exist strong discrepancies, which in recent years have widened, has motivated the attempt to find new hypotheses. A detailed analysis of appreciation process of the dollar in the early 1980's leads one to the conclusion that destabilizing currency speculation does actually exist. This "bubble" process has also been identified for the period between the end of 1972 and mid 1973 and for the year of 1978.To observe the configuration of relative price levels and relative real interest levels in time leads one to a new hypothesis about exchange rate dynamics. The expectation formation and the actual movements are explained by the interaction of disequilibria in the goods and asset markets (the exchange rate is thus conceived as both a flow price and an asset price).This disequilibrium approach rejects the validity of uncovered interest parity. The most important institutional condition for destabilizing currency speculation is identified as the basic asymmetry in capital mobility between asset holders and liability holders. This explains to a large extent how (first) debtors and (then) creditors and thus the whole international system has fallen into its current troubles. Finally, this paper concludes that exchange rates remain fundamentally unstable since one price cannot clear two markets (given the condition of freely floating short-term capital)