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Exchange Rate

Exchange Rate Models

Five Traditional Exchange Rate Models

The traditional exchange rate models seek for the identification of an equilibrium between two economies in order to calculate the fair value of the exchange rate.

The traditional exchange rate models seek for the identification of an equilibrium between two economies in order to calculate the fair value of the exchange rate. An equilibrium based on the relative valuation of an identical commodity, on relative inflation, on the relative level of real interest rates, etc.

These are the key exchange rate models and the relative pricing method they use:

  1. Purchasing Power Parity (PPP) → Relative pricing of goods ►More here
  2. Portfolio Balance Approach → Relative price of financial assets ►More here
  3. The Interest Rate Approach → Relative price of real interest rates ►More here
  4. Monetary Approach → Relative price of money More here
  5. Balance of Payments Approach → Balance of current and capital accounts ►More here

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Read more: Exchange Rate Models

Purchasing Power Parity (PPP)

1. PURCHASING POWER PARITY (PPP)

The Purchasing Power Parity (PPP) model or else the “law of one price” estimates the adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power.

 

PPP Basic Assumptions

PPP assumes that if there are no barriers to free trade the price of the same commodities must be the same everywhere in the world. Based on that assumption, the exchange rate between two economies must fluctuate towards a long-term value that ensures the equilibrium of commodity pricing.

Key Points regarding the PPP Analysis:

  • PPP analysis is based on several assumptions, including homogeneous products and absence of trade restrictions
  • PPP analysis can be used only for tradeable goods and not for non-tradeable goods such as services
  • In reality, only the prices of internationally traded goods tend to balance out
  • PPP analysis is useful for long-term currency valuation
  • There can significant divergences between currency valuations and PPP, especially in the short-term
  • PPP analysis is particularly useful for corporations, carry traders, and other long-term thinkers
  • PPP analysis is useless for short-term currency traders

 

Calculating the PPP

Basically, the price parity between two countries is formulated as:

■ e = Pd / Pf

This can be also expressed as:

Pd = e x Pf

where:

  • e = The PPP equilibrium exchange rate value
  • Pd = Domestic price level of a commodity
  • Pf = Foreign price level of a commodity
Read more: Purchasing Power Parity (PPP)

Monetary Exchange Rate Model

4. THE MONETARY APPROACH

 

The Monetary Approach focuses on the monetary policies of two countries in order to determine their currency exchange rate. The Monetary Approach uses two dynamics to determine an exchange rate, the price dynamics and the interest rates dynamics.

A change in the domestic money supply leads to a change in the level of prices and a change in the level of prices leads to a change in the exchange rate.

 

Monetary Approach Assumptions

The monetary model assumes:

(i) A freely-floating exchange rate regime (not a fixed exchange rate regime)

(ii) Minimal interventions by central banks

(iii) The aggregate supply curve is vertical

(iv) The prices of tradable goods are immediately adjusted to any change in the dynamics that affect them

(v) The transmission mechanism through prices to the exchange rate is immediate

 

The Monetary Policies

In general, a monetary policy focuses on the money supply of an economy. The available money supply is determined by:

(a) the amount of money in circulation, and

(b) the level of interest rates.

Countries that apply expansionary monetary policies in order to increase the amount of money in circulation will face inflationary pressures. This usually leads to a devaluation of the currency exchange rate. On the contrary, countries that apply tight monetary policies decrease the amount of money in circulation and see their currencies appreciate.

Read more: Monetary Exchange Rate Model

Portfolio Balance Approach

2. THE PORTFOLIO BALANCE APPROACH

The Portfolio Balance approach is a modern theory based on the relationship between the relative price of bonds and exchange rates.

 

The Portfolio Balance Approach Explained

The portfolio balance approach is an extension of the monetary exchange rate models focusing on the impact of bonds. According to this approach, any change in the economic conditions of a country will have a direct impact on the demand and supply for the domestic and the foreign bond. This shift in the demand/supply for bonds will in turn influence the exchange rate between the domestic and foreign economies.

The key advantage of the portfolio approach when compared to traditional approaches is that the financial assets tend to adjust considerably faster to news economic conditions than tradeable goods. Nevertheless, based on empirical evidence, the portfolio balance approach is not an accurate predictor of exchange rates.

 

The Assumptions of Portfolio Balance Approach

The portfolio balance approach is based on several assumptions:

1. The purchasing power parity (PPP) does not hold

2. The uncovered interest parity does not hold

3. The exchange rate is expected unchanged

4. Only three (3) assets are available for investment for each household: money, domestic bonds, and foreign bonds  

5. Bonds are not perfect substitutes

6. Assumes perfect capital mobility without capital controls and similar barriers to investment

7. Assumes narrow transaction costs and high completion in the money markets

Read more: Portfolio Balance Approach

Balance of Payments Model

5. THE BALANCE OF PAYMENTS APPROACH

 

According to the Balance of Payments theory, changes in a country’s national income affect the country’s current account. Consequently, the exchange rate is adjusting in a new level in order to achieve a new balance of payments equilibrium.

Before moving forward, let us define the balance of payments and the balance of trade.

 

What is the Balance of Payments?

The balance of payments is a general account that incorporates all the payments and receipts of the residents of a country in their transactions with residents of foreign countries. This account includes a great variety of transactions:

(i) Traded goods and services

(ii) Income from foreign investment

(iii) New investment

(iv) Foreign aid

(v) Capital flows between central banks and treasuries (cash or gold)

The annual payments and receipts of each country must be equal. Any inequality leads to a deficit or a surplus in the balance of payments.

■ Payments > Receipts = Deficit

■ Payments < Receipts = Surplus

The Current Account and the Capital Account

The balance of payments account contains two sub-accounts: the current and the capital accounts.

(i) The current account includes exports and imports of goods and services as well as unilateral transfers.

(ii) The capital account includes payments of debts and claims (no matter the time period)

Read more: Balance of Payments Model

Interest Rate Model

3. THE INTEREST RATE APPROACH & THE FISHER EFFECT

The connection between currency exchange rates and interest rate differentials appeared after the end of the Bretton Woods agreement in 1970-1972 (►what is Bretton Woods).

 

The interest-rate models assume that the global capital enjoys perfect mobility and that it will immediately take advantage of any interest rate differentials. A situation which is known as ‘Covered Interest Rate Arbitrage’.

Covered Interest Rate Arbitrage

According to covered interest rate arbitrage theory, the interest-rate arbitrage is always active and ensures the covered interest rate parity worldwide.

Interest Rate Parity (IRP)

Interest Rate Parity (IRP) assumes that the interest rate differential between two countries remains always equal to the differential calculated by using the forward exchange rate and the spot exchange rate. In other words, an exchange rate’s forward premium/discount equals its interest rate differential:

■ Forward premium/discount (%) = interest rate differential (%)

This creates an equilibrium based on the relationship between exchange rates and interest rates.

Read more: Interest Rate Model

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