Question

Discuss the different methods that are used to forecast exchange rate movements. Which method is the best and explain why?

Answer 1

Purchasing Power Parity

Purchasing power parity (PPP) is a commonly-used method based on the theory of the Law of One Price. This law states that identical goods should have identical prices, regardless of country. A Coke in Thailand should cost the same as a Coke in the US (after accounting for exchange rates and shipping).

PPP also accounts for inflation from country to country. If Thai prices are expected to go up by 3%, and US prices by only 1%, the inflation difference is 2%.

Thai prices will go up faster than US prices.

Therefore, the PPP approach forecasts that the Thai Baht would need to depreciate by about 2% to maintain parity.

Relative Economic Strength Approach

The relative economic strength approach is less precise than the PPP method. It is more of a general assessment of a country's currency rates. The relative economic strength approach looks to the economic growth in a given country. If an economy is stronger, you can make a fairly good assumption that this growth will attract investors.

In order to buy investments, you need to buy that country's currency. This should create an increase in demand, thus bumping up the currency rate.

High interest rates would also be a good sign for investors, also causing the currency to rise.

Econometric Models of Forecasting Exchange Rates

Another common method used to forecast exchange rates involves gathering factors that you believe affect currency movements and creating a model that relates these factors to the exchange rate. The factors used in econometric models are typically based on economic theory, but any variable can be added if it is believed to significantly influence the exchange rate.

As an example, suppose that a forecaster for a Canadian company has been tasked with forecasting the USD/CAD exchange rate over the next year. They believe an econometric model would be a good method to use and has researched factors they think affect the exchange rate.

The purchasing power parity (PPP) is perhaps the most popular method due to its indoctrination in most economic textbooks. The PPP forecasting approach is based off of the theoretical law of one price, which states that identical goods in different countries should have identical prices.