Theoretically the Bretton Woods system should avoid disequilibria by the automatic corrective mechanism described above, but in practice, the exchange rate shifts experimented in the UK in the 1950’s and 1960’s, proves it wrong.
Classical economics associated trade deficits with money supply changes. Its modern form appeared as a policy to prevent the increasing inflation of the 1970’s. Developed by David Hume, monetarism argues that an excess supply of money domestically will be reflected in an outflow across the foreign exchange. Growth in national income, associated with growing excess demand for money can be met in two ways: by credit creation or by balance of payment surplus. The economy induces an inflow of money via the foreign balance to the point were this money is not created by the central bank. According to the monetary approach, weakening currencies and high interest rates both flow from high relative money supply growth. Monetarism argues that exchange rate is a function of two main variables: money supply and income. If money supply increased, so would inflation, and therefore the home currency would experiment depreciation. If income was to increase and money supply was to be kept fixed, inflation will decrease and the currency will appreciate.
Still this seems not to be a complete theory for exchange rate determination, since money supply and prices tend to move slowly whereas exchange rates change rapidly, like share price movements.
The portfolio balance theory, is an extension of the monetary model, and extends on the idea that exchange rates are determined by the relative supply and demand for money at home. Portfolio theory introduces the idea of foreign money and foreign bonds being potential substitutes for bonds and money at home. If foreign and domestic bonds are perfect substitutes and assuming interest rates hold, there is no difference between the portfolio theory and the monetarist approach. Nevertheless, the portfolio theory states that in the short run, this assumption cannot be made, because exchange rates are determined in part by the relative demand and supply of money and in part by other assets. Agents may hold international portfolios of assets denominated in different currencies, making demand for money a more complex function. This theory also involves changes in exchange rates impacting wealth holders of assets denominated in foreign currency.
The portfolio theory shows a combination of interest rates and exchange rates for which the bong market is in equilibrium. In practice, if interest rates at home rise, investors will demand more domestic bonds, and the only way to reduce this excess demand is by the fall in the domestic currency value of foreign bonds. Thus, the home currency appreciates in value, reducing real wealth of the portfolio holders. Therefore, with a fixed supply of domestic bonds, equilibrium is maintained by the relation between the exchange rate and the domestic interest rate. The portfolio theory is in fact an extension of the monetary approach since it establishes the exchange rate as a function of foreign and domestic bond supply.
A model that seems to be quite efficient in short term exchange rate forecasting is Chartism. This technique involves the study of past price movements to seek the potential future trends. Chartism, also known as “technical analysis” makes its predictions upon the assumption that past price patterns will repeat. Therefore they are dedicated in finding trends and trend reversals as well as resistance levels, head-shoulders patterns and double-bottom patterns.
Movements along a price line, mark peaks and troughs in repeated patterns that create the so called resistance lines. Once one of the price changes breaches the resistance line, it is said to indicate a change of trend. A bubble-up formation will suppose a share is been rising steadily for some time when some investors sold to realize profits and it then rose to its maximum level for second time, before starting to fall again. Based on experience, the chartist would predict the trend has reversed or changed. In the case of the head-and-shoulders formation, there would be three peaks, characterised by the middle one being larger, and the other two being very similar, marking the head and shoulder shape and establishing the. The two minimums established by the shoulders mark the neck, once the change in price braches the neckline, a change of trend happens and it is an indication to sale. Oscillator are difference between the latest closing exchange rate and the closing exchange rate a specified number of days earlier. When plotted, oscillators often exhibit familiar chart patterns that can assist in identifying trend reversals.
The efficient market hypothesis is one of the most important propositions. It is based upon the assumption that markets for securities being composed of players out to maximise profit. Security prices adjust to all new information and can be found in three forms: weak form, semi-strong, and strong form efficient markets. Semi-strong efficient markets, reflect previous price movements in the security price, and therefore give no space to chartist analysis, wile semi-strong efficient markets assert security price move according to all public information, and strong form efficient market includes both public and private information therefore there is no monopolistic access to information. Western economies argue that there market reflects the semi-strong efficient model, although evidence is know challenging this argument.
The theories covered above are relevant in explaining systematic patterns of exchange rate behaviour or long-run behaviours such purchasing power parity or the Fisher effect. The value of these theories for predicting exchange rates is limited basically for the propensity of the unexpected to happen. The real world is characterised by unpredictable unexpected events or “shocks” that are referred to as news. Interest rates, prices and incomes are affected by “news” and the same is true for exchange rates. Periods dominated by unexpected events will result in great fluctuations in spot and forward exchange rates. Since exchange rates are financial asset prices that respond quickly to new information, news on prices will have an immediate impact on exchange rates. Periods dominated by news, observe exchange rates varying a great deal relative to prices, such as periods as the 1970’s the 1980’s and he early 1990’s, where many unexpected economic events occurred and consequently oil prices rose and debt problems appeared. In conclusion exchange rates will remain volatile, while world political events remain unpredictable and therefore no theory will be able to explain or predict exchange rate fluctuations with complete accuracy.
