The stability of currency values plays a significant role for economic and financial stability. It is not difficult to see the exchange rate fluctuations are widely regarded as damaging. As the movements of the exchange rate have significant and large effects on the trade balance, resource allocation, domestic prices, interest rate, national income and other key economic variables. Then can exchange rate movements be predicted by these fundamental economic variables?
Economists have long taken the view that economic fundamentals determine exchange rates. Nevertheless, in the early 1970s, after the collapse of fixed exchange rate regimes of the Bretton Woods system, excess volatility, nonlinear and disorderly movements in exchange rates became mysteries that traditional exchange rate theory cannot explain. Recent scholar concluded “no definitive evidence that economic variable can forecast exchange rate for currencies of nations with similar inflation rates" which is known as “the disconnect puzzle” from Meese and Rogoff’s studies (1983). Thus, this essay aims to explain why is it apparently so difficult to forecast exchange rate movements, and to provide evidence from the relevant literature and the reference of three popular fundamentals-based models, including Monetary Model and Mundell-Fleming Model.
To put it simply, the exchange rate is a price. As with any other market, price is determined by supply and demand. Whenever they are not equivalent, the exchange rate would change. However, the reality comes to be far more complicated.
The leading model, Monetary Model links exchange rate movements to the balance of payment, which is used for medium to long term analysis. The following assumptions constitute the building blocks of the Monetary Model. Firstly, the aggregate supply curve is vertical at all times, which implies perfect price flexibility that clear both money and good markets. Secondly, the purchasing power parity relationship, which ensures the equilibrium of exchange rate. Thirdly, the demand for money is a stable function of national income and price level by using the Cambridge quantity equation.
The most obvious problem is that these assumptions have simplified realities. The based assumptions, money demand equations, purchasing power parity perform poorly under the real world conditions (Engel 2000). The money demand equation has proven to be unstable, especially in the America and the purchasing power parity theory may not hold in the long run. Another problem is that the Monetary Model concentrates only on the equilibrium of money market and leave the fundamentals adjust freely to clear another five markets under the open economy. Moreover, income is an exogenous variable in the model, which implies consumption is depend on interest rather than income level. Consequently, since the building blocks of the Monetary Model have broken down, it surely cannot adequately explain or forecast the facts of...