August 22, 2001

Recent exchange rate movements puzzle some financial commentators. Several weeks ago some argued that the euro had been a failure because it has depreciated approximately 40% from its peak. Based on the euro depreciation, these people foresaw a corresponding surge in euro inflation. Another criticism of current international arrangements is that monetary authorities all over the world are failing to provide predictable, stable monetary policies. The question is how to tell whether the dollar is weak or the euro is strong. Interestingly, there is considerable agreement as to what the economic goals should be. However, there is considerable disagreement as to how those goals are achieved. The following shows that the theoretical framework underlying the analysis determines, in large part, the answer to this problem.

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