Question

Even though in the short term, currency values may deviate from the long-term fundamental path. In the long term however, the exchange rates do appear to follow a fundamental equilibrium path, one that is consistent with the fundamental theories of exchange rate determinants of exchange rates: parity conditions, the balance payments approach, and the asset market approach.

Discuss the strengths and issues of each.

Answer 1

Yes, in the short run currency values do deviate from the long term fundamental path. In the long run, the exchange rate does appear to follow a fundamental equilibrium path and that is consistent with the fundamental theories of exchange rate determination. The major exchange rate determinants are parity conditions, the balance payments approach, and the asset market approach.

• Parity Conditions: It states that the nominal exchange rate will adjust so that identical goods will have the same price in different markets. This is driven by the inflation rates, interest rates between two countries, forward rates, and principles of the parity in interest rates.
• The balance payments approach: This approach says that in the foreign exchange markets the exchange rates depend on the balance of payment between two countries based on the nature and value of the transactions in the current account and capital account. In the long run, inflows, and outflows of the currency matches.
• Asset market approach: The foreign exchange market comes in equilibrium in the long run based on the demand and supply equilibrium for the bonds and other financial instruments in the capital market.