4. 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

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 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)

Triffin Dilemma (Reserve Currency Paradox)

Robert, Baron Triffin was a Belgian-American economist who was openly against the Bretton Woods monetary system. Triffin dilemma or else Triffin paradox refers to countries whose currencies are used as global reserve currencies, like the United States and the US dollar.

Describing the Triffin Dilemma

Identified in the 1960s, the Triffin dilemma describes a situation where there is a conflict of interest between short-term domestic objectives and long-term international objectives. These are some facts regarding the country that is issuing the global reserve currency:

(1) The need for an extra supply of foreign exchange reserves

The country issuing the global reserve currency must supply other countries with an additional supply of its currency to meet the international demand for foreign exchange reserves.

Key Macroeconomic Indicators for Currency Trading

A list of some of the most important economic indicators when trading Forex currencies:

1. Interest Rates

• US: US interest rate decisions are made by FED 8 times per year

• ECB: The European Central Bank meets monthly to decide about its interest rates policy (Between the 10th and the 14th day of each month)

2. Gross Domestic Product

• US: US Advance GDP is released 1 month after the end of the quarter by the Bureau of Economic Analysis (BEA). The final GDP is released 3 months after the quarter’s end. GDP is released during the last week of each month.

•  Europe: Monthly by Eurostat

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.

Here are all the major factors affecting the fluctuations of global currencies.

1. Interest Rates

Central Banks and Interest Rates

The interest rates of an economy are adjusted by the domestic monetary authority, such as the FED in the US and the ECB in the Eurozone. When the interest rates of a particular currency increase, more investment funds are attracted and buy that currency to achieve a higher interest return. On the other hand, when interest rates are decreasing an exchange rate is less attractive to investment funds and thus it is expected to fall against other currencies.

Interest Rates Correlations

1) Interest Rates increase ↑ → market liquidity and inflation are expected to decrease ↓ → the domestic exchange rate increases ↑

2) Interest Rates decrease ↓ → market liquidity and inflation are expected to increase ↑ → the domestic exchange rate decreases ↓