Introduction
The stability of currency values plays a significant role for economic and financial stability. It is not difficult to see the exchange rate fluctuations are widely regarded as damaging. As the movements of the exchange rate have significant and large effects on the trade balance, resource allocation, domestic prices, interest rate, national income and other key economic variables. Then can exchange rate movements be predicted by these fundamental economic variables?
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.
To put it simply, the exchange rate is a price. As with any other market, price is determined by supply and demand. Whenever they are not equivalent, the exchange rate would change. However, the reality comes to be far more complicated.
Monetary Model
The leading model, Monetary Model links exchange rate movements to the balance of payment, which is used for medium to long term analysis. The following assumptions cons...
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...g and, inversely, it is the exchange rate that attains the predictability on these fundamentals.
Works Cited
Engel, Charles 2000, “Long-Run PPP May Not Hold After All”, Journal of International Economics, Vol. 51, no. 2, pp. 243-73.
Frankel, J 1996, 'How Well Do Foreign Exchange Markets Work: Might a Tobin Tax Help?', The Tobin tax: Coping with financial volatility, pp. 41-81, n.p.: New York and Oxford: Oxford University Press.
Kilian, L, & Taylor, M 2003, 'Why Is It So Difficult to Beat the Random Walk Forecast of Exchange Rates?', Journal Of International Economics, Vol. 60, no. 1, pp. 85-107.
Meese, R, & Rogoff, K 1983, 'Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?', Journal Of International Economics, Vol. 14, no. 1-2, pp. 3-24.
Wang, Jing 2008, ‘Why Are Exchange Rates So Difficult To Predict’, Economic Letter, Vol. 3, no. 6.
Meade (1988) stated that, because of the exchange rate rapid decline so much since early 1985 in the US and because the monthly trade statistics has been examined so thoroughly for any sign of a turnaround in the nominal trade balance, the J-curve phenomenon has received much attention. The statistics often implies that the negative effect of depreciation is reflected in the J-curve as the continuation of nominal trade deficit. Between early 1985 and 1988, the exchange value of US dollar in terms of currencies of other countries, registered a sizeable depreciation. The deficits recorded in the trade account were mirrored in the current account deficit. Meade depicted the significance of the exchange rate to the trade account as well as current account through the use of the J-curve highlighting that the phenomenon is used as a long-term goal to curb the deficits, however in the short-run, depreciation will increase the nominal deficits accumulated by a country.
Walker, Bruce. "Euro Likely to Keep Losing Value." The New American. The New American Magazine, 7 July 2010. Web. 23 May 2011. .
The second paper is that of Peridy (2003) which uses the Armington approach. The author finds that the impact of exchange rate volatility is misleading. The third paper using the Armington approach is that of Saito (2004), who uses the constant elasticity of substitution (CES) functional form of Sato (1967) and finds that Armington elasticities are higher for multilateral trade data than bilateral trade data. Lastly, there is the work of Byrne et al. (2006) which uses the Armington approach with similar utility function as in Saito (2004), finding that exchange rate uncertainty has a robust negative
Moffatt, M. (2014). Purchasing Power Parity: Link Between Exchange Rates and Inflation. Retrieved from: http://economics.about.com/od/purchasingpowerparity/a/ppp.htm
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