When it comes to exchange rate determination, several different theories exist. In this article, we wanted to address those theories. Of course, unless you are involved with world finances or the economy, some of this can be a little confusing but if you do trade currencies or work in finances or economics, these exchange rate determination theories would be interesting and possibly enlightening. The purpose of these theories is to help determine what exchange rates will do, which is a monumental task.
The different theories for exchange rate determination have come out of numerous studies. These variances are the result of different econometric methods being used and data being gathered and in truth, some of these theories are not used for forecasting movement of currencies in that they are not reliable. In addition, some of the theories used for exchange rate determination are better than others are which is why it is important for you to find the best model available and use it.
Keep in mind – the following theories for Exchange rate determination are just a few in existence.
• Purchasing Power Parity – Also referred to as “PPP”, this theory for exchange rate determination is based on inflation, something used in Spain during the 16th century. Using this model, the law of one price exists whereby the price of one good should be equal for the home currency as the country overseas. Many experts agree the benefit of this theory is that it helps with over or under currency valuation. However, PPP was established on the assumption that the market would be perfect, providing high information efficiency for goods markets, as well as foreign exchange markets.
• Interest Rate Parity – Ever since the development of the gold standard, policymakers regarding currency have discovered that exchange rates are influenced by monetary policy. A prime example is interest for a home rising, which typically means home appreciation follows.
• Mundell-Fleming – This theory for exchange rate determination was developed in case of an open economy. This theory therefore provides an understanding specific to the way the rate is determined. For the Mundell Fleming theory, goods, money, and assets are considered. Additionally, this theory is primarily used for analyzing impact on monetary and fiscal policies.
• Balassa-Samuelson – The one negative aspect of the PPP and Interest Parity theories for exchange rate determination is that producer and consumer behavior is not considered although price levels are through interaction associated with supply and demand. Because supply and demand of products is directly linked to the behavior of producers and consumers, exchange rate determination needs to be studied. This particular theory researches the way in which productivity affects the exchange rate.
• Dornbusch Overshooting – Another exchange rate determination theory is this one, which shows expectations and dynamics of exchange rates. Under this theory, the uncovered interest rate parity and money equilibrium of the simple monetary theory remain intact but the assumption of flexible prices changes.
• Obstfeld and Rogoff – Some of the other theories used for exchange rate determination do not have an adequate micro foundation, which means providing adequate current accounts and balances of international payments is challenging. With this theory, it is assumed that nominal prices would be associated with the producer’s currency, meaning the rates would pass through one hundred for every cent to consumer pricing, as well as an exchange rate that is flexible and therefore a great alternative for pricing of flexible goods.
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