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Learn about Exchange Rate ModelsThe Exchange Rate Models aim to forecast future exchange rates by analyzing certain monetary factors...

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 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 the absence of trade restrictions

  • PPP analysis can be used only for tradeable goods and not for non-tradable 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

Portfolio Balance Approach



The portfolio-balance approach is another model for exchange rate determination that is popular among Forex economists. More specifically, 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 of domestic and foreign bonds. 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 new economic conditions than tradeable goods. Nevertheless, based on empirical evidence, the portfolio balance approach is not an accurate predictor of exchange rates.

Interest Rate Approach



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 the 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.

The Monetary Approach



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

Balance of Payments Theory



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 to a new level 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)