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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. 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

 

 

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 in 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 actually 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

 

Links:

1. ► Purchasing Power Parity (PPP)
2. ► Portfolio Balance Approach
3. ► Interest Rate Approach
4. ► Monetary Approach
5. ► Balance of Payments Approach
6. ► Triffin Dilemma
7. ► Modern Monetary Theory (MMT)

 

■ Traditional Exchange Rate Models

George Protonotarios, Financial Analyst

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