The Three Economic Models of the Forex Market

By Justin Stewart

We have already seen the explanation of the 4 major economic theories that exist within the Forex market. These theories were labeled as follows:

1. Balance of Payments

2. Interest Rate Parity

3. International Fisher Effect

4. Purchasing Power Parity

Additionally, there are three secondary theories, but they have been labeled as models rather than theories, though they originate from economic theories to begin with.

Model #1 – The Asset Market Model
This particular model focuses on a country’s monetary influx by foreign investors who are purchasing certain financial instruments such as either bonds or stocks or both. Should a country begin to see a large inward flow of investments in their available financial instruments, they also expect to see an increase in the value of their currency. Obviously this makes sense since the investors need to convert their country’s currencies over to the particular currency rate of the nation in order to purchase the intended financial instruments.

The capital account of the trade balance is taken into consideration versus the current account balance of trade when the asset market model is used for investment purposes. Since the capital accounts of most countries are starting to outweigh their current account balances, this particular theory for investment is being applied more than the others based on international monetary flows that are created.

Model #2 – The Monetary Model
The focus of this particular model involves a country’s monetary policy as it relates to the determination of the currency exchange rate. The monetary policy of most countries deals with their monetary supplies, namely the amount of money that a country’s treasury prints. When this is combined with the interest rates that are set by their central banks, it will oftentimes determine the amounts of monetary supplies available.

The investor needs to be aware of the fact that this theory (along with all others) does help to illustrate the basic currency fundamentals and the way in which certain economic factors impact them. However, the investor also needs to be aware of the fact that most economic theories are based largely on two aspects:

* Assumptions made by the individuals involved in formulating the theory
* The existence of a perfect economic atmosphere in which to apply the theory

The main reason that none of the theories are 100% accurate in their predictions of currency fluctuations in the Forex market is due to the fact that there are so many of them and they all contain various conflicting aspects.

Model #3 – Real Interest Rate Differential Model
The adjustment of an interest rate in order to erase the effects that inflation has on it so as to reflect the true cost of money to the borrower and the true yield to the lender results in arriving at what is called the real interest rate. The formula for arriving at it is written as follows:

Nominal Interest Rate – Inflation (Expected or Actual) = Real Interest Rate

The theory suggests that a country that has a higher rate of interest will see the value of their currency appreciate against countries having a lower interest rate. The reason is that investors will move their money towards those countries whose interest rates are higher, therefore concluding that the currency rate will appreciate in value.