ECON303 Tutorial 3 Reading

ECON303 Tutorial 3 Reading - What's the Point of Credit...

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17 What Determines the Exchange Rate: Economic Factors or Market Sentiment? Gregory P. Hopper* R eaders of the financial press are familiar with the gyrations of the currency market. No matter which way currencies zig or zag, it seems there is always an analyst with a quot- able, ready explanation. Either interest rates are rising faster than expected in some country, or the trade balance is up or down, or central banks are tightening or loosening their mon- etary policies. Whatever the explanations, the underlying belief is that exchange rates are af- fected by fundamental economic forces, such as money supplies, interest rates, real output levels, or the trade balance, which, if well fore- casted, give the forecaster an advantage in pre- dicting the exchange rate. What is not so well known outside academia is that exchange rates don’t seem to be affected by economic fundamentals in the short run. Being able to predict money supplies, central bank policies, or other supposed influences doesn’t help forecast the exchange rate. Econo- mists have found instead that the best forecast of the exchange rate, at least in the short run, is whatever it happens to be today. *When this article was written, Greg Hopper was a se- nior economist in the Research Department of the Philadel- phia Fed. He is now in the Credit Analytics Group at Mor- gan Stanley, Co., Inc., New York.
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18 FEDERAL RESERVE BANK OF PHILADELPHIA BUSINESS REVIEW SEPTEMBER/OCTOBER 1997 In this article, we’ll review exchange-rate economics, focusing on what is predictable and what isn’t. We’ll see that exchange rates seem to be influenced by market sentiment rather than by economic fundamentals, and we’ll ex- amine the practical implications of this fact. Sometimes, there are situations in which mar- ket participants may be able to forecast the di- rection but not the timing of the movement. We’ll also see that volatility of exchange rates and correlations between exchange rates are predictable, and we’ll examine the implications for currency option pricing, risk management, and portfolio selection. THE EXCHANGE RATE AND ECONOMIC FUNDAMENTALS The earliest model of the exchange rate, the monetary model, assumes that the current ex- change rate is determined by current funda- mental economic variables: money supplies and output levels of the countries. When the fundamentals are combined with market ex- pectations of future exchange rates, the model yields the value of the current exchange rate. The monetary model might also be dubbed the “newspaper model.” When analyzing move- ments in the exchange rate, journalists often use the results of the monetary model. Simi- larly, when Wall Street analysts are asked to justify their exchange-rate predictions, they will typically resort to some variant of the monetary model. This model is popular because it pro- vides intuitive relationships between the eco- nomic fundamentals and it’s based on standard macroeconomic reasoning.
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ECON303 Tutorial 3 Reading - What's the Point of Credit...

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