8.1 Exchange Rate Determination Theories

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 Purchasing Power Parity and Interest Rate Parity 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 trade balances
  • 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
  • Absolute PPP states that the exchange rate between two currencies should equal the ratio of the price levels in the two countries
  • Relative PPP 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
  • Covered Interest Rate Parity (CIRP) involves the use of forward contracts to hedge against exchange rate risk, ensuring that the return on investment is the same across countries
  • Uncovered Interest Rate Parity (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 Balance of Payments (BOP) approach emphasizes the role of international capital flows and trade balances in determining exchange rates
  • A country with a current account surplus (more exports than imports) will experience an appreciation of its currency, while a current account deficit 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, monetary policy, 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)