CHAPTER 9
FOREIGN EXCHANGE RATE DETERMINATION
1. Exchange Rate Determination. What are the three basic theoretical approaches to exchange rate
determination?
Purchasing Power Parity Approach. The most widely accepted of all exchange rate determination
Asset Market Approach. The asset market approach, sometimes called the relative price of bonds
2. PPP Inadequacy. The most widely accepted theory of foreign exchange rate determination is
purchasing power parity, yet it has proven to quit poor at forecasting future spot exchange rates.
Why?
3. Data and the Balance of Payments Approach. Statistics on a country’s balance of payments are
used by the business press and business itself often in terms of predicting exchange rates, but the
academic profession is highly critical of it. Why?
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assets play no role in exchange rate determination in this theory, a weakness explored in the following
discussion of monetary and asset market approaches. Curiously, while the balance of payments
approach is largely dismissed by the academic community today, the practitioner public-market
participants, including currency traders themselves, still rely on different variations of this theory for
much of their decision making.
4. Supply and Demand. Which of the three major theoretical approaches seems to put the most weight
into arguments on the supply and demand for currency? What is its primary weakness?
The monetary approach focuses on changes in the supply and demand for money as the primary
determinant of inflation. Changes in relative inflation rates in turn are expected to alter exchange rates
5. Asset Market Approach to Forecasting. Explain how the asset market approach can be used to
forecast future spot exchange rates. How does the asset market approach differ from the BOP
approach to forecasting?
The asset market approach assumes that whether foreigners are willing to hold claims in monetary
form depends on an extensive set of investment considerations or drivers. These drivers include the
following:
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Speculation can cause a foreign exchange crisis, make an existing crisis worse, or both. We will
observe this effect through the three illustrative cases that follow shortly.
6. Technical Analysis. Explain how technical analysis can be used to forecast future spot exchange
rates. How does technical analysis differ from the BOP and asset market approaches to forecasting?
7. Intervention. What is foreign currency intervention? How is it accomplished?
Foreign currency intervention is the active management, manipulation, or intervention in the
8. Intervention Motivation. Why do governments and central banks intervene in the foreign exchange
markets? If markets are efficient, why not let them determine the value of a currency?
Historically, a primary motive for a government to pursue currency value change was to keep the
country’s currency cheap so that foreign buyers would find its exports cheap. This policy, long
9. Direct Intervention Usefulness. When is direct intervention likely to be the most successful? And
when is it likely to be the least successful?
10. Intervention Downside. What is the downside of both direct and indirect intervention?
It is important to remember that intervention may—and often does—fail. The Turkish currency crisis
11. Capital Controls. Are capital controls really a method of currency market intervention, or more of a
denial of activity? How does this fit with the concept of the impossible trinity?
This is the restriction of access to foreign currency by government. This involves limiting the ability
12. Asian Crisis of 1997 and Disequilibrium. What was the primary disequilibrium at work in Asia in
1997 that likely caused the Asian financial crisis? Do you think it could have been avoided?
The roots of the Asian currency crisis extended from a fundamental change in the economics of the
region, the transition of many Asian nations from being net exporters to net importers. Starting as
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13. Fundamental Equilibrium. What is meant by the term “fundamental equilibrium path” for a
currency value? What is “noise”?
14. Argentina’s Failure. What was the basis of the Argentine Currency Board, and why did it fail in
2002?
By 2001, crisis conditions had revealed three very important underlying problems with Argentina’s
15. Term Forecasting. What are the major differences between short-term and long-term forecasts for a
fixed exchange rate versus a floating exchange rate?
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important as technical factors in the marketplace, government intervention, news, and passing whims
of traders and investors. Accuracy of the forecast is critical because most of the exchange rate
changes are relatively small even though the day-to-day volatility may be high.
Forecasting services normally undertake fundamental economic analysis for long-term forecasts, and
some base their short-term forecasts on the same basic model. Others base their short-term forecasts
on technical analysis similar to that conducted in security analysis. They attempt to correlate
exchange rate changes with various other variables, regardless of whether there is any economic
rationale for the correlation. The chances of these forecasts being consistently useful or profitable
depends on whether one believes the foreign exchange market is efficient. The more efficient the
market is, the more likely it is that exchange rates are “random walks,” with past price behavior
providing no clues to the future. The less efficient the foreign exchange market is, the better the
chance that forecasters may get lucky and find a key relationship that holds, at least for the short run.
If the relationship is really consistent, however, others will soon discover it, and the market will
become efficient again with respect to that piece of information. Exhibit 9.9 summarizes the various
forecasting periods, regimes, and the authors’ opinions on the preferred methodologies.
16. Exchange Rate Dynamics. What is meant by the term “overshooting”? What causes it, and how is it
corrected?
Assume that the current spot rate between the dollar and the euro, as illustrated in Exhibit 9.9 in the
17. Foreign Currency Speculation. The emerging market crises of 1997–2002 were worsened because
of rampant speculation. Do speculators cause such crisis or do they simply respond to market signals
of weakness? How can a government manage foreign exchange speculation?
“Hot money” is a term used to describe funds held in one currency (country) that will move very
quickly to another currency as soon as it is deemed weak. Such a quick flow will create severe short-
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the currency crisis in a fundamental sense, but he may well have caused (and advanced) the timing of
what would have occurred eventually in any case.
18. Cross-Rate Consistency in Forecasting. Explain the meaning of “cross-rate consistency” as used by
MNEs. How do MNEs use a check of cross-rate consistency in practice?
19. Stabilizing Versus Destabilizing Expectations. Define stabilizing and destabilizing expectations,
and describe how they play a role in the long-term determination of exchange rates.
20. Currency Forecasting Services. Many multinational firms use forecasting services regularly. If
forecasting is essentially “foretelling the future,” and that is theoretically impossible, why would
these firms spend money on these services?