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Is Economic Theory Useful for Predicting Future Exchange Rates? 

There is countless strategies and methods used for exchange rate predictability amongst both industry professionals and retail traders. Fundamental indicators such as employment, inflation and interest rate data to technical analysis and the use of historic price data - there is no 'secret' strategy to making money in the forex market.

The foreign exchange market is incredibly dynamic and fast paced and as such, traders are very diverse with their plans. It is important to find a trading plan that suits personal risk tolerances, time horizons, execution styles and much more. Although, professional traders tend to have extremely large amount of capital at their disposal which allows for more complex strategies that could involve hedging techniques using derivates, or perhaps a wider fundamental bias that has led them to open a position. In the retail space, traders using leverages accounts tend to stick with short term technical patterns and tight stop losses to capitalise on shorter term moves. With all this in mind, it begs the question as to the role of economic theory and if it holds any predictive ability - if so, how to utlisize it.

1) Purchasing Power Parity (PPP)

A basic theory of long run exchange rate determination that equalises price differentials across countries. 

2) The Balassa-Samuelson Model 

Following on from traditional PPP, The Balassa Samuelson model uses productivity differences in the traded and non-traded goods sectors to explain systematic deviations in reported figures of prices, wages and national income which were calculated using exchange rates and purchasing power parity. 

3) Covered Interest Parity (CIP)

Covered Interest Parity is a condition that describes the relationship between interest rates with spot and forward exchange rates. Theoretically, the condition is satisfied when there are no arbitrage opportunities.

4) Uncovered Interest Parity (UIP)

A theory stating that the difference in interest rates between nations will equal the relative change to their currency valuations in the same period.

5) The Monetary Approach 

A direct outgrowth of PPP and quantity theory of money, the monetary approach is best considered a theory of long run exchange rate behaviour. 

6) The Dornbusch Model

A hybrid of the monetary and Mundell-Fleming models, The Dornbusch theory of exchange rates combines fixed short run principles with long run flexible principles.

Economic Theories 

There are several economic theories of exchange rate determination which are listed above, each of which containing differing characteristics therefore providing different findings in the literature with regards to predictive ability. Much like fundamental analysis, economic theories focus on a much wider perspective than technical analysis would, but none the less can be a useful tool for developing a long term directional bias, and are often over-looked. Whether this is applied directly to the foreign exchange market or assists in trading other correlated markets, thats for the trader to decide.

The Bottom Line

In the real world, these theories tend to be used more by Institutions such as the International Monetary Fund, WHO, Central Banks and Governments for international comparisons between countries and assisting with future policy measures. The scope of these theories are typically out with the realms of day traders speculating on foreign currency movements.

By: A SWEENEY | Updated Mar 14th 2021
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