Macroeconomics is a branch of economics that studies general economic factors and large-scale events to predict economic behavior and decision-making of the economy as a whole. The three major concerns of Macroeconomics are employment, inflation, and National output.

General Factors Affecting Exchange Rates

Similar to any other financial price, the price of an exchange rate is determined by the forces of demand and supply. The price of an exchange rate reflects many economic and non-economic factors. The most important factors are interest rates, inflation, growth, employment, and political risk.

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Five (5) 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. Equilibrium is based on the relative valuation of an identical commodity, relative inflation, the relative level of real interest rates, etc.

Modern Monetary Theory or Modern Money Theory (MMT)

The Modern Monetary Theory is an alternative to the traditional macroeconomic theory. Generally, MMT suggests that there is no limit to the quantity of money that can be created by a central bank. The only limit comes from the impact of inflation. In short, MMT suggests that countries and governments controlling reserve currencies can borrow and spend as much as they need to achieve employment, and later, create more currency to repay their debt.

MMT Economists are focused on fiscal policies

According to MMT, governments can create new money through their fiscal policy. The government’s fiscal policy is focused on budgeting and includes:

• Taxation

• Government spending, and

• Transfer payments

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.

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 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

  Read more: Purchasing Power Parity (PPP)

2. THE 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.

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 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.