The Economic Theories That Affect Foreign Exchange Rates

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This article is about the economic theories related to foreign exchange rates.

Foreign Exchange Rates and Economic Theories

Many people are in two minds as to whether they should leave their conventional careers to enter the foreign exchange market.  It is a massive step to take, but it could be an extremely exciting one.  The potential to make profits in the forex market is there, but you have to learn as much as you can about the workings of the market.  You should trade with care and implement suitable risk levels.  This market used to be the domain of the central banks, governments and large financial institutions, but this exciting world has now been opened to individual investors.

Economic theories

The foreign exchange market is filled with economic theories.  Many of the theories are not applicable to the forex market, but you should be aware of it.  One of the important theories found in this market is the one related to conditions of parity.

Purchasing Power Parity

This economic theory is related to the law of one price.  The law states that a basic item’s price in one country should match that of another country.  This should be so once the foreign exchange rates variance has been accounted for.  If the price still varies after the exchange rate difference adjustment, there is the opportunity for the item to be bought in the country that offers it at a lower price and dispose of it in another country, at a profit.

Balance of Payments

The balance of payments of a country consists of two sections.  The first is the current account and the second, the capital account.  These accounts are used as a point of measure of the inflow and outflow of goods and services.  The current account is related to the theory of the balance of payments.  The current account reflects the trade of tangible goods in a country.

The theory states that if a country shows a large current account deficit or surplus, it means that its foreign exchange rates are out of balance.  To rectify this problem, it would be necessary to adjust the forex rate over a specific time period.  Countries that indicate a large deficit shows that the imports exceeded the exports.  This will cause its currency rate to decline.  The opposite situation exists if the country is experiencing a surplus in its current account.  The foreign exchange rates in the country will increase in value.  The method of calculation of the balance of payments is:

  • Reserves account balance + capital account balance + current account balance = 0

Interest Rate Parity Related To Foreign Exchange Rates

This concept is similar to the one related to purchasing power parity.  The main suggestion is to eliminate the arbitrage opportunity by making sure that the same assets available in different countries attract the same interest rates.  This should be so provided the risk for each is similar.  The basics of the theory are the same as that for purchasing power parity.

Interest Rate Difference

The economic model related to interest rate difference states that countries with higher real interest rates will normally experience an increased foreign exchange rate value when compared to countries that have lower interest rates.  The one main reason for this is that global investors always look for higher return on their investment and will move their funds accordingly.

 

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