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Exchange rates equilibrate the supply and demand for currencies in foreign exchange markets. Purchasing power parity (PPP) states that the real exchange rate (purchasing power) is equalized across countries in the long run; the nominal rate adjusts to offset inflation differences. Deviations from PPP reflect differences in asset returns, interest rates, and inflation expectations. Exchange rate dynamics are highly volatile in the short run because currency markets respond immediately to financial news about interest rates and return differentials; connections to fundamentals are weaker in the short run.
From the Mundell-Fleming model, you know that in an open economy with capital mobility, monetary and fiscal policy have different effects depending on whether the exchange rate is fixed or floating. Exchange rate dynamics takes this further by asking: what determines the level and movement of exchange rates over time, and why are currency markets so much more volatile than the goods markets they supposedly reflect?
Purchasing power parity (PPP) provides the long-run anchor. The idea is intuitive: if the same basket of goods costs $100 in the United States and €90 in Europe, the exchange rate should be roughly $1.11 per euro, because otherwise identical goods would be cheaper in one country, creating arbitrage opportunities. Absolute PPP says the exchange rate equals the ratio of price levels; relative PPP says the exchange rate changes at a rate equal to the inflation differential. If U.S. inflation runs 2 percentage points above European inflation, the dollar should depreciate by 2% per year against the euro. Empirically, relative PPP holds reasonably well over decades but fails badly over months and years — real exchange rates can deviate from PPP for prolonged periods.
The short-run disconnect between exchange rates and price levels arises because currencies are financial assets, not just units for pricing goods. The uncovered interest parity (UIP) condition states that the expected return on holding domestic and foreign bonds should be equal when expressed in a common currency. If U.S. interest rates rise above European rates, investors buy dollar-denominated assets, appreciating the dollar *immediately* — but UIP predicts the dollar must then be expected to *depreciate* over time to equalize returns. This creates the characteristic pattern of exchange rate overshooting, formalized by Rudiger Dornbusch: because goods prices are sticky while asset prices adjust instantly, a monetary contraction causes the exchange rate to jump beyond its new long-run equilibrium and then gradually return. The exchange rate does more work in the short run precisely because prices cannot adjust quickly enough.
This framework explains why exchange rates are notoriously difficult to forecast. In the short run, they respond to interest rate surprises, risk sentiment, capital flow reversals, and speculative positioning — all of which move faster and less predictably than inflation or trade balances. The connection to fundamentals (PPP, current accounts, productivity differentials) reasserts itself only over horizons of several years. For policymakers, the implication is that exchange rate movements are a powerful but unpredictable transmission channel: a central bank raising interest rates will strengthen the currency, tightening financial conditions through both the interest rate and the exchange rate, but the magnitude and timing of the currency response are inherently uncertain.