In order for forecasters to determine the true value of currency for different countries, they use different theories. While some theories are somewhat controversial, others are considered the best and therefore, the preferred choice. In this article, we wanted to address the different exchange rate theories so you can see some of the ways in which professional forecasters come up with information that is then provided to the public.
Keep in mind that when it comes to exchange rate theories, there are more beyond these mentioned but the theories provided below are considered the ones used most often.
• Marshall Lerner – This is one of the exchange rate theories that forecasters used, which takes an elasticity approach. This theory focuses on the relationship between exchange rates and the current account balance. With this, the framework is extended that includes income effects. Because of this, the analysis of adjustment problems is enabled.
• Monetary Approach – Another one of the exchange rate theories often used is this, which has an emphasis on the exchange rate being the relative price of two currencies. In this case, money demand plays a vital role specific to the adjustment process but also in determining the levels for the exchange rate.
• Obstfeld and Rogoff – In some cases, forecasters have a difficult time determining adequate current accounts and balances for international payments. Because of this, the Obstfeld and Rogoff theory is used, which requires rates to pass through one hundred per cent to consumer pricing. In addition, this theory requires the exchange rate to be flexible.
• Purchasing Power Parity (PPP) – Probably among the more popular exchange rate theories used, the PPP works off inflation. With this, law of one price would be in place so the price of one good should be equal. This particular foreign exchange rate model was first established on the assumption that he market would be ideal so information for the efficiency of goods and foreign exchange markets would be solid.
• Interest Rate Parity – From the time the Gold Standard was devised, currency policymakers knew that exchange rates were influenced by monetary policy. For this reason, the Interest Rate Parity was developed as one of the exchange rate theories.
• Mundell-Fleming – For this, an exchange rate is determined on an open economy. In this case, goods, money, and assets are considered for coming up with an accurate rate exchange. With this theory, an analysis of effect on fiscal and monetary policies is determined.
• Dornbusch Overshooting – Next on our list of exchange rate theories is this one, which is meant to show various dynamics and expectations of exchange rates. With this, the uncovered interest rate parity and money equilibrium of the simple monetary theory would not change as long as there are flexible price changes.
• Balassa-Samuelson – The last one of the exchange rate theories we wanted to mention is this, which works with productivity and the way in which it affects the exchange rate.
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