Exchange rates have proven to be a very important concept which determines international trade across nations – both in terms of risk determination (foreign currency risk) and for investors to make more calculated decisions. Exchange rate is defined as the price at which one nation’s currency can be converted to another. The puzzling nature of exchange rate determination can be owed to the greater volatility of exchange rates as compared to the macroeconomic fundamentals used for its determination and also due to model misspecification. In order to prove the difficulty in exchange rate forecasting, three structural models have been described, the monetary, the Mundell-Fleming and the Dornbusch model.
The Monetary Model – Flexible Prices
The monetary model is the earliest approach to exchange rate determination and serves as a benchmark from which later models have been developed. It relies on the assumptions of a vertical aggregate supply curve that indicates price flexibility, proportionality in the demand and supply for money and absolute Purchasing Power Parity (PPP). The monetary model of floating and fixed exchange rate regimes deduce that domestic currency will depreciate when domestic money stock increases and in the case of fixed exchange rate, the level of reserves decrease. In both cases for depreciation of domestic currency, domestic national income and foreign price levels decline. In a two country scenario, the domestic currency will depreciate when the foreign prices fall. In the event of domestic currency depreciation, the exchange rate appreciates and vice versa.
Drawbacks:
• The monetary model, although a useful establishment, can only be used to determine exchange rates in the long run due to its reli...
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...ately causing a significant change in the impact of such a monetary expansion
• The model makes the unrealistic assumption that the economic environment is entirely static, this doesn’t account for the changes to the global economy as a reaction to the pound’s depreciation
Economists have made several attempts to overcome some of these by extending the models; however, either due to lack of data or insufficient compatibility with predictions, their research has invariably fallen through. Research has been done to overcome the difficulty of prediction by incorporating nonlinearity of data, however even this only proves viable only over two to three years. This goes to prove that despite advancement in all other respects, the field of economics and international finance is still in need of a thorough means of exchange rate forecasting.
More recently, Bahamani-Oskooee and Ratha (2007) gave a synopsis of the J-curve phenomenon, the expectations and effects that will occur under this phenomenon. They stated that due to lag structure, currency devaluation or depreciation is said to worsen the trade balance first and improve it later resulting in a pattern that resemble the letter J, hence the J-Curve phenomenon. This phenomenon tests the short-run dynamics of the post-devaluation or depreciation time-path of the trade balance. While exchange rate ...
Economic indicators often affect and influence the value of a country's currency. The Trade Deficit, the Gross National Product (GNP), Industrial Production, the Unemployment Rate, and Business Inventories are examples of economic indicators. We will be dealing with four specific indicators: interest rate, inflation, unemployment, and employment growth, as well as Real Gross Domestic Product (GDP). Real GDP is so called because the effects of inflation and depreciation are accounted for in the figures. The state of the economy is important both on a micro and macroeconomic level.
Poole W. The monetary policy model. Business Economics [serial online]. October 2006;41(4):7-10. Available from: EconLit with Full Text, Ipswich, MA. Accessed January 10, 2012.
Historically, this is outlined in the domestic societal framework (a rationalist point of view dictating political outcomes as a direct result of domestic material interests in society). Whatever society wants, society gets, leaving the consumer is to benefit from a fixed exchange rate. Competition exists between all interests. Whatever interest dominates takes the winning interest. The winning interest, then, determines the outcome. With businesses facing pressure to decrease domestic prices, consumers now have the upper hand. (Wellhausen, 10-2-14). Thus, due to the enhancing credibility of the government, consumers also are to benefit from a fixed exchange rate. (Multiple governments
In the present day, the world's economy is ever-changing and adjusting. Many different reasons control the reasons for this. The future of currency is something that can only be predicted and is not guaranteed. However, there are many determing factors behind the changes that can take place. Asia and North America are two continents that have economies that have recently changed or are in the midst of change.
A traditional analysis gives a mistakenly high value to dollars in the future, money in the future is given the same value as money today; but in reality, money in the fu...
International investing is something that many investors find that they can benefit from for many reasons. Two of the main reasons why investors choose to invest in foreign markets are growth and diversification. Growth allows investors the potential to take advantage of new opportunities in foreign emerging markets. International markets can potentially offer opportunities that might not be available in the United States. Diversification allows investors to spread out their risk to different markets and foreign companies other than those just in the United States allowing them to potentially create larger returns on their investment as well as reducing risks. (U.S. Securities and Exchange Commission, 2012) While investing internationally can be a very lucrative and rewarding decision, there are also extra risks involved with investing internationally. One of the main risks that international investors encounter is foreign exchange risk also known as currency risk. Currency risk is a financial risk that is created by contact with unforeseen changes in the exchange rate between two currencies. These changes can cause unpredictable gains or losses when profits from investments are converted from a foreign currency to the United Stated dollar. There are precautions that can be taken by investors to potentially lower their risk of currency value fluctuations and other risk factors that are present in international investing. (Gibley, 2012)
Walker, Bruce. "Euro Likely to Keep Losing Value." The New American. The New American Magazine, 7 July 2010. Web. 23 May 2011. .
Other types of exchange rate risks are translation risk and so-called hidden risk. The translation risk relates to cases where large multinational companies have subsidiaries in other countries. On the financial statement of the whole group, the company may have to translate the assets and liabilities from foreign accounts into the group statement. The translation will involve foreign exchange exposure. The term hidden risk evolves around the fact that all companies are subject to exchange rate risks, even if they don’t do business with companies using other currencies. A company that is buying supplies from a local manufacturer might be affected of fluctuating foreign exchange rates if the local manufacturer is doing business with overseas companies. If a manufacturer goes out of business, or experience heavy losses, it will affect all the companies it does business with. The co...
There have been deliberations about the ideal exchange rate system for a period of time, dazzling the advancement of the world economy and the manner of monetary policy.
Economists have long taken the view that economic fundamentals determine exchange rates. Nevertheless, in the early 1970s, after the collapse of fixed exchange rate regimes of the Bretton Woods system, excess volatility, nonlinear and disorderly movements in exchange rates became mysteries that traditional exchange rate theory cannot explain. Recent scholar concluded “no definitive evidence that economic variable can forecast exchange rate for currencies of nations with similar inflation rates" which is known as “the disconnect puzzle” from Meese and Rogoff’s studies (1983). Thus, this essay aims to explain why is it apparently so difficult to forecast exchange rate movements, and to provide evidence from the relevant literature and the reference of three popular fundamentals-based models, including Monetary Model and Mundell-Fleming Model.
The International Fisher Effect – Dealing with interest rate differentials and expected change in spot foreign exchange rates
The foreign exchange market is one of important mechanism in the international business because foreign exchange is an intermediary for all nations in term of the growth of the economy. There are many functions of foreign exchange market in the global economy. In the international business, it uses the foreign exchange markets in four ways. First, the pay...
Because this rate, along with the nominal, are constantly in use in the global economy, these rates can fluctuate depending on a range of factors ...
Daily in the USA about 38 million banknotes of various face value for total amount about 541 million dollars are issued (Facts about USA money).Dollars involve deep consequences both for the USA, and for other countries. Increase of its course relatively reduces the volume of export revenue in dollars, quite often involves more considerable, than change of an exchange rate, falling of the world prices, especially on raw materials. On the contrary, decrease in a dollar rate serves as the powerful tool promoting growth of the American export and a pushing off of competitors of the USA in foreign markets. At the same time import to the USA owing to effect of a rise in prices restrains. Thus, for the USA changes in the exchange rate of dollar anyway bring benefits and advantages.Reduction of leading positions of the USA in world economy is assisted by the international role of dollar which remains the main reserve and settlement means in world monetary system. Foreign currency reserves of the central banks of other countries for 61% consist of dollars, nearly 2/3 calculations in world trade are carried out in dollars; the dollar serves as a measure of value of many important goods (for example: oil) in the world market; in dollars 3/4 international bank crediting is made (Aleksandr Popov). Changes in the exchange rate of dollar involve deep consequences both for the USA, and for other countries. Increase of its course relatively reduces the volume of export revenue in dollars, quite often involves more considerable, than change of an exchange rate, falling of the world prices, especially on raw materials. On the contrary, decrease in a dollar rate serves as the powerful tool promoting growth of the American export and a pushing off...