Question

Expound on a holistic view of exchange rate determination. Address the technical, efficiency and fundamental views of ERs. Give examples of technical and efficiency determination of ERs

Answer 1

Expound on a holistic view of exchange rate determination. Address the technical, efficiency and fundamental views of ERs. Give examples of technical and efficiency determination of ERs

Exchange rates between the currencies of the countries are determined based on multiple factors. There are many theories to support how the exchange rates are determined in the market. These are the fundamental views. Some of the views these theories present are –

Purchasing Power Parity- this theory proposes that the exchange rates between two countries in long term is determined by the inflation index of the two countries. Country where the inflation is higher will see a depreciation of their currency as compared to a country with lower inflation. This view is related to long-term real exchange rates.

Covered Interest Rate Parity- this theory suggests that currency of a country with higher interest rate will depreciate with respect to a country with lower interest rate. This is because the time value of money will be lower in a country with higher interest rate. This theory dictates the medium to long-term nominal exchange rates. The forward rates are often based on this theory. However, there are other factors that affect the affect the short-term exchange rates between two countries, which cause the nominal exchange rates to deviate from their theoretical value.

Domestic Savings and Investment rate- a country where domestic savings are lower than the capital investments in the country will need to have a flow of capital from foreign markets to supports its capital investments and growth. Hence, the government in these countries will artificially keep the exchange rates lower or more favorable to its currency to support the flow of funds in the economy. This theory helps explain long-term deviations in the exchange rates from the theoretical exchange rates as explained by covered interest rate parity theory. This scenario is widely observed in developing countries like Russia, India, Indonesia etc.

Above are the theoretical supports for the exchange rates observed between countries. However, there are some factors that impact the currency exchange rates in real life. These are primarily technical and efficiency related views. They are as follows –

Ease of Flow of Capital- Governments in some countries, which have a closed or restricted economy control the flow of capital in and out of the economy and often artificially control the exchange rates. The primary reason for these actions is to control flow of capital in the economy and maintain exchange rates at certain level. One classical example is China, who has artificially controlled the exchange rates and prevented their currency from appreciating to remain compatible in the global exports markets.

Development of Capital Markets- this issue is relate to the openness of the overall economy. exchange rates are determined by flow of capital in and out of the economy. If a country has poorly developed or restricted capital markets, then the currencies of such countries will not trade in the international open currency markets and there will be no price discovery for determining exchange rates. Due to low volumes, the exchange rates will often be ‘sticky’, where the rates do not change real time but move in large steps. This is often seen in case small and under-developed economies like smaller islands or poor countries in Africa or South America.

Cross currency movements- Sometimes, the currency of a country is thinly traded in the international currency markets. There are very few dealers who have the capability to deal in these currencies globally. Hence, not many cross-currency quotes are not available for them. As a result, the traders cannot make profit from the arbitrage, even when the currency is mispriced. Any discrepancy or pricing anomaly persists for longer time. The cross-currency trades to profits from the arbitrage has high transaction costs. This is usually the case with under-developed economies and small, isolated countries.

Having considered all the views, it becomes clear that for better exchange rates, open economy and integration with global economy is necessary.