Chapter 5 Models of Exchange-rate Determination

Chapter 5 Models of Exchange-rate Determination
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Lead-in

The dollar was hemmed into a narrow trading range on May 19, 2020, as traders’ focus shifted to U.S.President Donald Trump’s response to China’s passage of a national security law for Hong Kong Special Administrative Region of China.The yuan fell in onshore trade and remained near a record low in offshore trade as markets turned nervous before Trump’s announcement later on Friday of policy moves that could ignite a diplomatic row between Washington and Beijing.The greenback was on course for a weekly loss against major currencies as progress in lifting coronavirus lockdowns and stimulus plans in Europe weakened demand for safe havens, but the mood could quickly worsen if Sino-U.S.tensions increase.

Source: The Economic Times, May 29, 2020, https://economictimes.indiatimes.com/markets/ forex/dollar-bides-time-yuan-falls-before-trump-takes-stage-on-china/articleshow/76082776.cms

The current system of floating exchange rates has focused attention on the importance of managing exchange rate risk.This involves forecasting exchange rates and taking measures to protect against potential unfavorable developments.Understanding the underlying forces that determine exchange rates and why they are likely to vary is a fundamental and indispensable tool for judicious financial decision making.

The international parity relations, embodied in the writings of J.M.Keynes, G.Cassel and I.Fisher, form the basis of most analysis of exchange rate behavior.They are an elegant set of simple equilibrium relationships between the prices of goods and services, interest rates, and the spot and forward exchange rates.Although they are highly stylized and depend on some demonstrably unrealistic assumptions, they constitute a powerful theoretical framework for understanding and explaining the international financial environment.