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Key Exchange Rate Theories

Five Traditional Exchange Rate Theories...Five Traditional Exchange Rate Theories


The traditional exchange rate models seek the identification of an equilibrium between two economies to calculate the fair value of the exchange rate. An equilibrium is based on the relative valuation of an identical commodity, relative inflation, 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

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

  • 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

  • There can be 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

» Purchasing Power Parity (PPP)


2. Portfolio Balance Approach → Relative price of financial assets

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

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.

» Portfolio Balance Approach


3. The Interest Rate Approach → Relative price of real interest rates

The connection between currency exchange rates and interest rate differentials appeared after the end of the Bretton Woods agreement in 1970-1972 

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 is known as ‘Covered Interest Rate Arbitrage’.

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.

» Interest Rate Approach



4. Monetary Approach → Relative price of money

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

(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 Approach


5. Balance of Payments Approach → Balance of current and capital accounts

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.

The Relationship between the National Income, the Current Account, and the Exchange Rate

Assuming that the level of interest rate is stable, if the national income of a country is rising, the demand for foreign goods is rising too. That stronger demand leads to an increased amount of imports and a new equilibrium in the current account balance. In that case, the exchange rate of the country works as a transmission mechanism for restoring the balance of payments equilibrium. Practically, the exchange rate of that country will depreciate to make imports more expensive and thus restore the balance between exports and imports.

On the other hand, if the national income is falling, the imports will shrink and the exchange rate will appreciate restoring the equilibrium in the current account balance.

» Balance of Payments Theory


Conclusions -12 Key Points Regarding the Five Traditional Exchange Rate Models

The analysis of a traditional exchange rate model can offer useful insight for long-term traders and currency strategists regarding the long-term trend of an exchange rate. These are some conclusions derived from empirical evidence

  1. The traditional exchange rate models are based on several assumptions which are rarely met in real economic conditions

  2. The traditional exchange rate models hold better from a long-term perspective

  3. The traditional exchange rate models are practically useless for predicting short-term currency fluctuations

  4. These models are useful for long-term investors and macro analysts but not for currency speculators and other short-term traders

  5. About 90% of the aggregate Forex market volume has speculative characteristics and that means that the key market movers ignore the analysis of classical exchange rate models

  6. The trade flows, which are used by many classical methods such as the PPP, the Balance of payments, and the Monetary Approach, make up only 1–2% of the aggregate Forex market volume, nowadays

  7. On the other hand, the importance of asset-based models has grown exponentially as portfolio flows boomed over the past three decades. Direct investment has proved also a key currency driver

  8. The financial markets react considerably faster to changing economic conditions than goods markets

  9. The asset-based models assume perfect asset substitutability and perfect capital mobility without capital controls, transaction costs, and similar barriers to investment. In reality, that is almost impossible

  10. The Foreign Exchange market is aligned with interest rate differentials but it tends to anticipate the movements of interest rates before they happen

  11. The reaction of investors to an interest rate change can’t be predicted with accuracy by any static economic model

  12. The Interest Rate Parity and the two Fisher theories hold better for emerging economies. Developed economies are in general more complicated than emerging economies


■ Key Exchange Rate Theories

George Protonotarios, Financial Analyst

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