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https://slidetodoc.com/chapter-10-foreign-exchange-rate-determination-and-forecasting/
- Exchange rate determination is complex: The three major schools of thought are international parity conditions, the balance of payments approach, and the asset market approach.
- In addition to focusing on the asset market approach, the monetary approach and the technical analysis are also introduced in this chapter •
- These are not competing but rather complementary theories, so understanding all of them can enhance our ability to capture the complexity of global currency markets and exchange rates
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- The theory of Purchasing Power Parity states that the exchange rate is determined as the relative prices of goods
- PPP is the oldest and most widely followed exchange rate theory • Paul Krugman, Nobel Prize laureate in Economics in 2008, said that “Under the skin an international economist lies a deep -seated belief in some variant of the PPP theory of the exchange rate”
- Most exchange rate determination theories have PPP elements embedded within their frameworks
- However, PPP calculations and forecasts are plagued with structural differences across countries (e. g. , different tax rules or many non-tradable production factors) and significant challenges of data collecting in estimation
- The Balance of Payments (Flows) approach argues that the equilibrium exchange rate is determined through the demand supply of currency flows from current and financial account activities:
- The BOP method is the second most utilized theoretical approach in exchange rate determination • Today, this method is largely dismissed by academics , but practitioners still rely on different variations of theory for decision making –
- This framework is appealing since the BOP transaction data is readily available and widely reported
- Critics may argue that this theory emphasizes on flows of currency, but stocks of currency or financial assets of residents play no role in exchange rate determination • The monetary approach considers the currency stocks of residents • The asset market approach argues that exchange rates are altered by shifts in the supply and demand of financial assets.
The Monetary Approach
The Monetary Approach states that the
supply and demand for currency stocks, as well as the expected growth
rates of currency stocks, will determine the price level or the inflation
rate and thus explain changes of the exchange rate according to PPP
–
·
The arguments are all about currency stocks of residents
–
·
The inference is to link the demand or the supply of
currencies with residents’ behavior to adjust the stock of currencies •
Main results of the monetary approach are as follows:
·
Currency supply ↑ è domestic currency
depreciation
o 1. Currency supply ↑
=> supply of currency > demand of currency => residents’ current currency
holding > residents’ desired currency holding => residents spend
the currency => price level ↑ => according to PPP, domestic currency
depreciates
o 2. Domestic currency supply
growth rate > foreign currency supply => growth rate domestic
currency depreciates vs. foreign currency
·
Interest rate ↑ è domestic currency
depreciation
o
1. Interest rate ↑ à opportunity cost for
residents to hold the currency increases à demand of currency ↓ à residents’
current currency holding > residents’ desired currency holding à residents spend the
currency à price level ↑à according to PPP, domestic currency
depreciates
o
2. Increase of domestic interest rate > increase of foreign
interest rate à domestic currency depreciates against foreign currency –
·
Real income ↑ è domestic currency
appreciation
o
1. Real income ↑ (= real GDP ↑ = outputs of
products and services ↑) à number of
transactions à ↑ demand of currency ↑ à residents’
current currency holding < residents’ desired currency holding à residents decrease
the spending of the currency price level ↓ (or because the supply of products and
services ↑, price level ↓ and less currency is spent to achieve the same
utility) à according to PPP, domestic currency appreciates
o
2. Domestic real income growth rate > foreign real income
growth rate (domestic economic growth > foreign economic growth) à domestic currency
appreciates against foreign currency
The Asset Market Approach
·
The Asset Market Approach argues that the exchange rate
should be determined by expectations about the future of an economy, not
current trade flows •
·
Since the prospect of an economy is reflected on the demand
of financial assets in that economy, the asset market approach believes that
changes of exchange rates are affected by changes of the supply and demand for
a wide variety of financial assets:
o
Shifts in the supply and demand for financial assets
alter exchange rates (not the demand supply of financial assets determine the
exchange rate)
o
The asset market approach is also called the relative price
of bonds or portfolio balance approach
o
More specifically, if the demand for domestic financial
assets increases, the demand for the domestic currency will increase,
which could results in the appreciation of the domestic currency –
o
Changes in monetary and fiscal policy alter expected returns
and perceived relative risks of financial assets, which in turn alter the
demand supply of financial assets and thus exchange rates (In the 1980 s, many
macroeconomic theories focused on this topic)
·
The asset market approach assumes that the motives of
foreigners to hold claims in one currency depends on an extensive set of
investment considerations or drivers:
o
1. Relative real interest rates (an important concern for
investing in foreign bonds and money market instruments)
o
2. Prospects for economic growth (the major reason for
crossborder equity investment and foreign direct investment)
o
3. Capital market liquidity (Cross-border investors are not
only interested in investing assets to earn higher returns, but also in being
able to sell assets quickly for fair market value)
o
4. A country’s economic and social infrastructure (which is
an indicator of that country’s ability to survive in unexpected external
stocks)
o
5. Political safety (which is usually reflected in political
risk premiums for a country’s securities)
o
6. Corporate governance practices (poor corporate governance
practices can reduce the investing will of foreign investors)
o
7. Contagion (which is the spread of a crisis in one country
to its neighboring countries, and can cause an innocent country to experience
capital flight and a resulting depreciation of its currency)
o
8. Speculation (can cause a foreign exchange crisis or make
an existing crisis worse)
·
※In summary, the asset market approach believes
that the above factors affect the motives of investments from both domestic and
foreign investors and thus affect the exchange rat
Technical
analysis
Technical analysis is based on the belief that
the study of past price behaviors provides insights into future price movements
–
Due to the poor forecasting performance of many fundamental
theories, the technical analysis draws more attention and becomes popular
–
The primary assumption of the technical analysis is that the movements
of any market driven price (e. g. , exchange rates) must follow trends
–
More specifically, technical analysts, traditionally referred
to as chartists, focus on price and volume data to identify trends that are
expected to continue into the future and next exploit trends to make profit
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