Tuesday, April 21, 2015

Economic Fundamentals

Theories of Exchange Rate Determination
Fundamentals may be classified into economic factors, financial factors,
political factors, and crises. Economic factors differ from the other three
factors in terms of the certainty of their release. The dates and times of
economic data release are known well in advance, at least among the
industrialized nations. Below are given briefly several known theories of
exchange rate determination.
Purchasing Power Parity
Purchasing power parity states that the price of a good in one country
should equal the price of the same good in another country, exchanged at the
current rate—the law of one price. There are two versions of the purchasing
power parity theory: the absolute version and the relative version. Under the
absolute version, the exchange rate simply equals the ratio of the two
countries' general price levels, which is the weighted average of all goods
produced in a country. However, this version works only if it is possible to find
two countries, which produce or consume the same goods. Moreover, the
absolute version assumes that transportation costs and trade barriers are
insignificant. In reality, transportation costs are significant and dissimilar
around the world.

Trade barriers are still alive and well, sometimes obvious and
sometimes hidden, and they influence costs and goods distribution.
Finally, this version disregards the importance of brand names. For
example, cars are chosen not only based on the best price for the same type
of car, but also on the basis of the name ("You are what you drive").

The PPP Relative Version
Under the relative version, the percentage change in the exchange rate
from a given base period must equal the difference between the percentage
change in the domestic price level and the percentage change in the foreign
price level. The relative version of the PPP is also not free of problems: it is
difficult or arbitrary to define the base period, trade restrictions remain a real
and thorny issue, just as with the absolute version, different price index
weighting and the inclusion of different products in the indexes make the
comparison difficult and in the long term, countries' internal price ratios may
change, causing the exchange rate to move away from the relative PPP.
In conclusion, the spot exchange rate moves independently of relative
domestic and foreign prices. In the short run, the exchange rate is influenced
by financial and not by commodity market conditions.
Theory of Elasticities
The theory of elasticities holds that the exchange rate is simply the
price of foreign exchange that maintains the balance of payments in
equilibrium. For instance, if the imports of country A are strong, then the
trade balance is weak. Consequently, the exchange rate rises, leading to the
growth of country A's exports, and triggers in turn a rise in its domestic
income, along with a decrease in its foreign income. Whereas a rise in the
domestic income (in country A) will trigger an increase in the domestic

consumption of both domestic and foreign goods and, therefore, more
demand for foreign currencies, a decrease in the foreign income (in country
B) will trigger a decrease in the domestic consumption of both country B's
domestic and foreign goods, and therefore less demand for its own currency.
The elasticities approach is not problem-free because in the short term
the exchange rate is more inelastic than it is in the long term and the
additional exchange rate variables arise continuously, changing the rules of
the game.
Modern Monetary Theories on Short-Term Exchange Rate Volatility
The modern monetary theories on short-term exchange rate volatility
take into consideration the short-term capital markets' role and the long-term
impact of the commodity markets on foreign exchange. These theories hold
that the divergence between the exchange rate and the purchasing power
parity is due to the supply and demand for financial assets and the
international capability.
One of the modern monetary theories states that exchange rate
volatility is triggered by a one-time domestic money supply increase, because
this is assumed to raise expectations of higher future monetary growth.
The purchasing power parity theory is extended to include the capital
markets. If, in both countries whose currencies are exchanged, the demand

for money is determined by the level of domestic income and domestic
interest rates, then a higher income increases demand for transactions
balances while a higher interest rate increases the opportunity cost of holding
money, reducing the demand for money.
Under a second approach, the exchange rate adjusts instantaneously to
maintain continuous interest rate parity, but only in the long run to maintain
PPP.
Volatility occurs because the commodity markets adjust more slowly
than the financial markets. This version is known as the dynamic monetary
approach.
The Portfolio-Balance Approach
The portfolio-balance approach holds that currency demand is triggered
by the demand for financial assets, rather than the demand for the currency
per se.
Synthesis of Traditional and Modern Monetary Views
In order to better suit the previous theories to the realities of the
market, some of the more stringent conditions were adjusted into a synthesis
of the traditional and modern monetary theories.
A short-term capital outflow induced by a monetary shock creates a
payments imbalance that requires an exchange rate change to maintain

balance of payments equilibrium. Speculative forces, commodity markets
disturbances, and the existence of short-term capital mobility trigger the
exchange rate volatility. The degree of change in the exchange rate is a
function of consumers' elasticity of demand.
Because the financial markets adjust faster than the commodities
markets, the exchange rate tends to be affected in the short term by capital
market changes, and in the long term by commodities changes.
















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