An Integrated Theory of Exchange Rate Equilibrium

Abstract

This brief paper will show that (a) a theoretical equilibrium state of the world exists in the absence of capital controls and trade barriers when prices for the same goods in different markets are equal, after translation at the spot exchange rate; (b) differences in rates of aggregate price change in different markets eventually cause offsetting exchange rate changes which restore condition (a); (c) returns on equivalent securities denominated in different currencies but covered in the forward market are almost instantaneously equalized; (d) the market's expected rate of change of the exchange rate equals, to a close approximation, the control-free interest rate differential between the two currencies; (e) in the absence of predictable exchange market intervention by central banks, the interest rate differential is the best possible forecaster of the future spot rate; and (f) the forward rate also provides the best forecast of the future spot rate. A final corollary identifies a relationship between inflation rates and international interest rate differentials.