Forecasting Exchange Rate
Forecasting
Exchange Rate
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Exchange
rate is affected by trade flow and capital flow.
Higher
interest rate will generally appreciate domestic currency but in the extreme
can depreciate as it stifle the economy.
- Relative Form of
Purchasing Power Parity (PPP)
Only valid for long term
Change of exchange rate is the difference of
inflation
- Relative
economic strength
Investors invest in country with more
favorable investment climate.
High short-term interest rate will bid up the
currency value.
Low short-term will cause borrow and when
return will push down the currency value.
- Capital Flow
Approach
Focus at long term capital flow
- Savings-investment
imbalances approach
When saving is not enough, need foreign
capital inflow to fund investments. Thus, have to keep interest rate high and
strong currency. But this will hurt current account.
But eventually currency will depreciate when
the expansion slow down and saving increases
- Government intervention: But
small because government trades is only a very small portion in the
currency demand and supply.
Bonds
depend on the inflation and interest rate. When economy is expanding, stock has
a better return than bonds.
Although
low interest rate helps stock, but if the yield curve is downward sloping, this
also means a contraction in economy. Better to invest in bond.