Hopper: What Determines the Exchange Rate?

Hopper, GP. 1997. What Determines the Exchange Rate: Economic Factors or Market Sentiment? Business Review 5: 17-29.

"Readers 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 quotable, 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 monetary policies. Whatever the explanations, the underlying belief is that exchange rates are affected by fundamental economic forces, such as money supplies, interest rates, real output levels or the trade balance, which, if well forecasted, give the forecaster an advantage in predicting the exchange rate" (17).

However, it doesn't seem like exchange rates are affected by short-term fundamentals. "Economists have found instead that the best forecast of the exchange rate, at least in the short run, is whatever it happens to be today" (17).

"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 examine the practical implications of this fact...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" (18).

Exchange rate is supposed to be determined by current levels of monetary supplies and country output. Exchange rates are determined by what amount of money can be exchanged for a similar good in a given country. The prices of those goods are determined mainly by money supply levels. If, for example, money supply raises in one country ceteris paribus, this will raise prices in that country and will make that currency exchange at a different rate with the rest of the world. The reason that overall output is taken into consideration is because, when output rises, ceteris paribus, prices will fall (there is more out there but the same amount of money to buy it) and the currency will appreciate against the world.

This is all incredibly problematic because it's an open system and fundamentals are not actually known. Also, the model is problematic because it assumes that price levels can move freely and that they are not "sticky" (19).

Other models: Dornbusch developed the overshooting model, "...in which the average level of prices is assumed to be fixed in the short run to reflect the real-world finding that many prices don't change frequently" (19). Portfolio Balance Model: "In this approach, the supply of and demand for foreign and domestic bonds, along with the supply of and demand for foreign and domestic money, determine the exchange rate" (19-20).

News about the fundamentals may be more informative than the fundamentals (20). This news would change exchange rates if it differed from market expectation.

The key: Market Sentiment Matters in exchange rate determination.