8.1 Exchange Rate Determination Theories
5 min read•july 30, 2024
Exchange rates are like a financial tug-of-war between currencies. They're shaped by short-term factors like interest rates and market sentiment, as well as long-term influences like inflation and productivity. Understanding these forces helps us navigate the global economy.
Theories like and try to explain exchange rates. But real-world currency movements are complex, influenced by expectations, speculation, and market sentiment. Knowing these theories' strengths and limitations is key for making sense of the forex market.
Exchange rate determinants
Short-run factors
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- Exchange rates are determined by the interaction of supply and demand for different currencies in foreign exchange markets
- In the short run, exchange rates are influenced by factors such as interest rate differentials, economic data releases, geopolitical events, and market sentiment
- Higher interest rates attract capital inflows, leading to currency appreciation, while lower interest rates can lead to capital outflows and currency depreciation (US dollar strengthening due to Federal Reserve rate hikes)
- Positive economic data releases, such as strong GDP growth or low unemployment, can strengthen a currency, while negative data can weaken it (better-than-expected US jobs report boosting the dollar)
- Geopolitical events, such as political instability, trade disputes, or natural disasters, can cause short-term volatility in exchange rates (Brexit uncertainty impacting the British pound)
Long-run factors
- In the long run, exchange rates are primarily determined by fundamental economic factors, including relative inflation rates, productivity levels, and
- Countries with higher inflation rates tend to experience currency depreciation over time, as their purchasing power declines relative to other currencies (Venezuelan bolívar depreciation due to hyperinflation)
- Differences in productivity growth can influence long-term exchange rate movements, with more productive economies typically experiencing currency appreciation (Japanese yen appreciation during the 1980s due to high productivity growth)
- Persistent trade imbalances, such as large current account deficits, can put downward pressure on a currency in the long run (US dollar vulnerability due to persistent current account deficits)
Parity theories vs other approaches
Purchasing Power Parity (PPP)
- Purchasing Power Parity (PPP) theory suggests that exchange rates should adjust to equalize the prices of goods and services across countries
- states that the exchange rate between two currencies should equal the ratio of the price levels in the two countries
- focuses on the relationship between the change in exchange rates and the change in relative price levels over time
- PPP is more applicable in the long run and for countries with similar economic structures and tradable goods (Big Mac Index comparing burger prices across countries)
Interest Rate Parity (IRP)
- Interest Rate Parity (IRP) theory posits that the difference in interest rates between two countries should be equal to the expected change in the exchange rate between their currencies
- (CIRP) involves the use of forward contracts to hedge against exchange rate risk, ensuring that the return on investment is the same across countries
- (UIRP) relies on the assumption that the expected change in the exchange rate is equal to the actual change, without the use of forward contracts (carry trades exploiting interest rate differentials)
Balance of Payments (BOP) approach
- The (BOP) approach emphasizes the role of international and trade balances in determining exchange rates
- A country with a (more exports than imports) will experience an appreciation of its currency, while a will lead to depreciation (Chinese yuan appreciation due to large trade surpluses)
- Capital account surpluses, resulting from net inflows of foreign investment, can also lead to currency appreciation, while capital account deficits can cause depreciation (US dollar strength due to high demand for US assets)
- The PPP, IRP, and BOP approaches offer different perspectives on exchange rate determination, focusing on goods markets, financial markets, and international trade and investment flows, respectively
Expectations and exchange rates
Market expectations
- Market participants' expectations about future economic conditions, , and geopolitical events can significantly influence short-term exchange rate movements
- If investors expect higher interest rates or stronger economic growth in a country, they may buy its currency in anticipation of future appreciation, leading to a self-fulfilling prophecy (euro appreciation in anticipation of European Central Bank rate hikes)
- Expectations of political instability, trade disputes, or other adverse events can lead to a sell-off of a country's currency (Turkish lira depreciation due to political uncertainty)
Speculation and market sentiment
- Speculation in foreign exchange markets can amplify short-term exchange rate fluctuations and cause deviations from fundamental values
- Speculative trading, such as carry trades or momentum strategies, can create short-term demand or supply imbalances, leading to overshooting or undershooting of exchange rates (Japanese yen carry trades during low-interest rate periods)
- Large-scale speculative flows can sometimes overwhelm the impact of economic fundamentals, particularly in the short run (George Soros's speculative attack on the British pound in 1992)
- Market sentiment, driven by investor psychology and risk appetite, can also contribute to short-term exchange rate volatility
- During periods of risk aversion, investors may flock to safe-haven currencies, such as the US dollar or Japanese yen, leading to their appreciation (Swiss franc appreciation during the European debt crisis)
- Conversely, during risk-on periods, investors may seek higher returns in riskier or higher-yielding currencies, causing their appreciation (Australian dollar strength during commodity booms)
- Central bank communication and forward guidance can shape market expectations and sentiment, influencing exchange rates even in the absence of actual policy changes (European Central Bank's "whatever it takes" speech calming markets)
Exchange rate theory effectiveness
Limitations of exchange rate theories
- While exchange rate determination theories provide useful frameworks for understanding currency movements, they have limitations in explaining real-world exchange rate behavior
- PPP theory has been found to hold better in the long run, but deviations from PPP can persist for extended periods due to factors such as trade barriers, non-tradable goods, and differences in consumption baskets across countries (persistent overvaluation of the Swiss franc relative to PPP)
- Interest Rate Parity (IRP) assumes perfect capital mobility and risk neutrality, which may not always hold in practice. Deviations from IRP can occur due to transaction costs, political risks, and differences in default risk across countries (emerging market currency volatility during financial crises)
- The Balance of Payments (BOP) approach provides insights into the role of trade and capital flows but may not fully capture the complexity of exchange rate dynamics in an increasingly interconnected global financial system (global imbalances and the paradox of thrift)
Improving exchange rate forecasting
- Exchange rate models based on economic fundamentals often struggle to outperform random walk forecasts in the short run, highlighting the importance of expectations, speculation, and market sentiment (Meese-Rogoff exchange rate forecasting puzzle)
- Combining insights from different exchange rate determination theories and considering the specific context of each currency pair can help improve the understanding and forecasting of exchange rate movements (use of hybrid models incorporating both fundamental and behavioral factors)
- Policymakers and market participants should be aware of the limitations of exchange rate models and use them in conjunction with other analytical tools and judgment when making decisions in real-world scenarios (central banks using a range of indicators and models to guide policy decisions)
Key Terms to Review (22)
Absolute ppp: Absolute Purchasing Power Parity (PPP) is an economic theory that states that in the absence of transportation costs and barriers to trade, the exchange rate between two currencies will adjust to reflect the relative price levels of a similar basket of goods in different countries. This concept connects the cost of living across nations, suggesting that identical goods should have the same price when expressed in a common currency.
Asset market model: The asset market model is a framework that explains how exchange rates are determined by the supply and demand for different financial assets, such as stocks, bonds, and currencies. This model posits that exchange rates reflect the relative attractiveness of holding assets in different currencies, influenced by factors like interest rates, inflation expectations, and political stability. By focusing on the behavior of investors in financial markets, the asset market model connects the dynamics of asset prices with fluctuations in currency values.
Balance of payments: The balance of payments is a comprehensive record of a country's economic transactions with the rest of the world over a specific period, reflecting all trade in goods and services, investment flows, and financial transfers. This crucial economic indicator helps analyze a nation's economic standing and influences exchange rate determination, monetary policy, and international capital flows.
Capital Flows: Capital flows refer to the movement of money for investment, trade, or business production across borders. These flows can take various forms, such as foreign direct investment (FDI), portfolio investment, and bank loans. Understanding capital flows is crucial because they impact exchange rates, influence monetary policy, and shape economic conditions in both sending and receiving countries.
Covered Interest Rate Parity: Covered interest rate parity is an economic theory that describes the relationship between interest rates and currency exchange rates, ensuring that there are no arbitrage opportunities in the foreign exchange market when forward contracts are utilized. It indicates that the difference in interest rates between two countries is equal to the differential between the forward exchange rate and the spot exchange rate, meaning that investors should be indifferent between investing domestically or abroad when taking into account hedging against exchange rate risk.
Currency manipulation: Currency manipulation refers to the practice of a government or central bank intentionally influencing the value of its currency to gain an unfair competitive advantage in international trade. This can involve actions like selling their own currency to lower its value or buying foreign currencies to increase their value. Such practices can distort exchange rates, affect trade balances, and lead to tensions in the global economy.
Currency overvaluation: Currency overvaluation occurs when a country's currency is priced higher than its true market value based on economic fundamentals. This situation can arise from various factors such as government interventions, excessive capital inflows, or speculative trading. When a currency is overvalued, it can lead to a decrease in export competitiveness and an increase in imports, which can ultimately harm the economy.
Current account deficit: A current account deficit occurs when a country's total imports of goods, services, and transfers exceed its total exports. This imbalance indicates that the nation is spending more on foreign trade than it is earning, which can lead to borrowing from foreign sources to cover the difference. Understanding this concept is essential as it relates to exchange rates, international capital flows, and potential currency crises, as persistent deficits can impact a country's economic stability and its currency value.
Current account surplus: A current account surplus occurs when a country's total exports of goods, services, and income exceed its total imports over a specific period. This situation indicates that a country is earning more from its trade and investments abroad than it is spending on foreign goods and services, which can affect exchange rates and a country’s economic health. A persistent surplus can lead to currency appreciation and may influence the global balance of payments and reserve currency status.
Exchange rate shocks: Exchange rate shocks refer to sudden and unexpected changes in the value of a currency relative to others, often due to economic events or policy changes. These shocks can significantly impact trade balances, inflation rates, and economic growth, influencing global financial markets and the economy as a whole.
Fiscal Policy: Fiscal policy refers to the use of government spending and taxation to influence a nation's economy. It plays a crucial role in managing economic fluctuations, promoting growth, and achieving macroeconomic stability. By adjusting these financial levers, governments can stimulate demand during economic downturns or cool off an overheating economy, making it essential in the context of exchange rate determination theories as it directly impacts interest rates and capital flows between countries.
Fixed exchange rate: A fixed exchange rate is a monetary system where a country's currency value is tied or pegged to another major currency or a basket of currencies, maintaining a stable exchange rate over time. This system is crucial for promoting trade stability, as it reduces the risk of exchange rate fluctuations that can affect international transactions.
Floating Exchange Rate: A floating exchange rate is a currency system where the value of a currency is determined by market forces, primarily supply and demand, rather than being fixed or pegged to another currency. This dynamic nature allows for adjustments in response to economic conditions, trade balances, and speculation, impacting monetary policy decisions and international trade relationships.
Forex intervention: Forex intervention refers to the actions taken by a country's central bank or government to influence the value of its currency in the foreign exchange market. This is often done to stabilize or manipulate exchange rates, impacting trade balances, inflation, and overall economic performance. By buying or selling their own currency against foreign currencies, authorities aim to achieve desired economic outcomes, reflecting the interplay between monetary policy and exchange rate determination theories.
Interest Rate Parity: Interest rate parity is a fundamental principle in international finance that states the relationship between interest rates and exchange rates should be such that an investor cannot achieve arbitrage profits by capitalizing on differences in interest rates between two countries. This concept helps to explain how capital flows and currency exchange rates are influenced by interest rates, which is crucial for understanding the dynamics of currency markets and international trade.
Milton Friedman: Milton Friedman was a renowned American economist and a leading advocate of monetarism, emphasizing the role of government in regulating the economy through monetary policy. His work challenged existing economic paradigms, promoting the idea that changes in the money supply have significant effects on inflation and economic stability.
Monetary policy: Monetary policy refers to the actions taken by a central bank to manage the money supply and interest rates in an economy to achieve specific economic objectives such as controlling inflation, managing employment levels, and stabilizing the currency. It is a vital tool for influencing economic activity and is closely related to the functioning of central banks, the structure of financial institutions, and broader economic dynamics.
Purchasing Power Parity: Purchasing Power Parity (PPP) is an economic theory that states that in the long run, exchange rates between currencies should adjust so that identical goods cost the same in different countries. This principle is crucial for understanding how currency values relate to the cost of living and inflation across nations, highlighting the importance of relative prices in shaping exchange rate movements.
Relative ppp: Relative purchasing power parity (PPP) is an economic theory that suggests that the rate of change in the exchange rate between two currencies over time is proportional to the change in price levels in the respective countries. This concept is vital in understanding how inflation rates impact currency values and helps predict future exchange rates based on expected inflation differentials.
Speculative attacks: Speculative attacks occur when investors sell off a country's currency in large volumes, usually in anticipation of a decline in its value. This behavior can destabilize the currency's value and lead to significant economic consequences, often forcing governments to alter their monetary policies. Such attacks are typically driven by perceptions of an overvalued currency or unsustainable economic fundamentals.
Trade balances: Trade balances refer to the difference between a country's exports and imports of goods and services over a specific period. A positive trade balance, or surplus, occurs when exports exceed imports, while a negative trade balance, or deficit, arises when imports surpass exports. This concept is crucial for understanding how countries engage with each other economically and affects exchange rates and overall economic health.
Uncovered Interest Rate Parity: Uncovered interest rate parity is an economic theory that posits that the difference in interest rates between two countries will equal the expected change in exchange rates between their currencies. This concept plays a critical role in understanding how currency values are influenced by differences in interest rates, helping to establish expectations about future exchange rate movements based on interest rate differentials.