The Economics of Exchange Rates (Collected Works of Harry Johnson)

CHAPTER 5

RATIONAL EXPECTATIONS AND THE EXCHANGE RATE

JOHN F. O. BILSON

International Monetary FundNorthwestern University

I. INTRODUCTION

The model of exchange rate determination presented here combines elements of the “efficient market” and “monetary” approaches to asset markets.¹ The monetary aspects of the model arise through the assumption that the exchange rate, as the relative price of two monies, is primarily determined by the relative supplies and demands for these monies, and that the relevant demand and supply functions are stable functions of a small number of variables.² An “efficient market” is one in which all opportunities for profit are eliminated, implying, in the absence of transactions costs, that the law of one price will ...