Elsewhere in this book, households have stationary or neutral expectations. Goods prices, interest rates, and the exchange rate prevailing currently are expected to prevail in the future. Under this simple supposition, the nominal interest rates, r0 and r1 represent real interest rates, ex ante, because the expected inflation rate is zero. Furthermore, the foreign interest rate, r0, represents the full rate of return on the foreign bond, because changes in capital values are not anticipated when exchange-rate changes are not anticipated.

This assumption is restrictive. It might indeed be said to violate the spirit of the asset-market approach, which argues that exchange rates are determined in the short run by behavior in bond and money markets based on anticipated rates of return. Expectations about rates of return are affected by forecasts of changes in asset prices, including changes in exchange rates, which alter differentially expected returns on assets denominated in different currencies. It is not enough to say, as we did in Chapter 2, that wealth holders are uncertain about the future and hold foreign-currency assets in their portfolios to hedge against exchange-rate changes. We must introduce nonneutral expectations to replicate exchange-rate behavior realistically.

In the first section of this chapter we show how nonneutral expectations can be introduced into the simplified model summarized in Chapter 7. Next we introduce a convenient way to endogenize those expectations. Households are assumed to have farsighted or hyperopic vision, rather than nearsighted or myopic vision.