Macroeconomics is a branch of economics that studies general economic factors and large-scale events to predict economic behavior and decision-making of the economy as a whole. The three major concerns of Macroeconomics are employment, inflation, and National output.
Traditional Exchange Rate Theories
The traditional exchange rate models seek the identification of an equilibrium between two economies in order to calculate the fair value of the exchange rate. Equilibrium is based on the relative valuation of an identical commodity, relative inflation, the relative level of real interest rates, etc.
Key Points Regarding the Five Traditional Exchange Rate Models
The analysis of a traditional exchange rate model can offer useful insight for long-term traders and currency strategists regarding the long-term trend of an exchange rate. These are some conclusions derived from empirical evidence
- The traditional exchange rate models are based on several assumptions which are rarely met in real economic conditions
- The traditional exchange rate models hold better in a long-term perspective
- The traditional exchange rate models are practically useless for predicting short-term currency fluctuations
- These models are useful for long-term investors and macro analysts but not for currency speculators and other short-term traders
- About 90% of the aggregate Forex market volume has speculative characteristics and that means that the key market movers ignore the analysis of classical exchange rate models
- The trade flows, which are used by many classical methods such as the PPP, the Balance of payments, and the Monetary Approach, make up only 1–2% of the aggregate Forex market volume, nowadays
- On the other hand, the importance of asset-based models has grown exponentially as portfolio flows boomed over the past three decades. Direct investment has proved also a key currency driver
- The financial markets react considerably faster to changing economic conditions than goods markets
- The asset-based models assume perfect asset substitutability and perfect capital mobility without capital controls, transaction costs, and similar barriers to investment. In reality, that is almost impossible
- The Foreign Exchange market is aligned with interest rate differentials but it tends to anticipate the movements of interest rates before they actually happen
- The reaction of investors to an interest rate change can’t be predicted with accuracy by any static economic model
- The Interest Rate Parity and the two Fisher theories hold better for emerging economies. Developed economies are in general more complicated than emerging economies
1. Purchasing Power Parity (PPP) → Relative pricing of goods
The Purchasing Power Parity (PPP) model or else the “law of one price” estimates the adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power.
2. Portfolio Balance Approach → Relative price of financial assets
The Portfolio Balance approach is a modern theory based on the relationship between the relative price of bonds and exchange rates.
3. The Interest Rate Approach → Relative price of real interest rates
The connection between currency exchange rates and interest rate differentials appeared after the end of the Bretton Woods agreement in 1970-1972
4. Monetary Approach → Relative price of money
The Monetary Approach focuses on the monetary policies of two countries in order to determine their currency exchange rate. The Monetary Approach uses two dynamics to determine an exchange rate, the price dynamics and the interest rates dynamics.
5. Balance of Payments Approach → Balance of current and capital accounts
According to the Balance of Payments theory, changes in a country’s national income affect the country’s current account. Consequently, the exchange rate is adjusting in a new level in order to achieve a new balance of payments equilibrium.
Triffin Dilemma (Reserve Currency Paradox)
Robert, Baron Triffin was a Belgian-American economist who was openly against the Bretton Woods monetary system. Triffin dilemma or else Triffin paradox refers to countries whose currencies are used as global reserve currencies, like the United States and the US dollar.
Identified in the 1960s, the Triffin dilemma describes a situation where there is a conflict of interest between short-term domestic objectives and long-term international objectives.
Modern Monetary Theory (MMT)
The Modern Monetary Theory is an alternative to the traditional macroeconomic theory. Generally, MMT suggests that there is no limit to the quantity of money that can be created by a central bank. The only limit comes from the impact of inflation.
Key Macroeconomic Indicators for Currency Trading
A list of some of the most important macroeconomic indicators when trading Forex currencies:
- Interest Rates
- Gross Domestic Product
- Consumer Price Index / Inflation Reports
- Retail Sales
- Trade Balance
- Purchasing Manufacturing Index (PMI)
- Consumer Confidence Survey