Why It Is Difficult To Forecast Exchange Rate Movement: An Analysis Of Monetary Models

Challenges Associated with Forecasting Exchange Rate Movement

Discuss about the International Money and Finance for Global Business.

Exchange rate movement is a common phenomenon in global business and it is associated with depreciation, appreciation, devaluation or revaluation. Depreciation and devaluation refer to the downwards movements while appreciation and revaluation represent the upward movement. Forecasting the exchange movement has been difficult due to the complex interrelated factor affecting the exchange rate. It is important to forecast the exchange rate because of the prolonged depreciation that may occur and lead to losses in business. Several models have been developed to help in predicting the exchange rate movements and this helps investors, organizations and other stakeholders to make good financial decisions effectively. Unfortunately, it’s perplexing to estimate exchange rates especially for a short period of time (Harvey, 2005). Gross Domestic Product (GDP), inflation, business balance and many factors that cause economic disparities in different countries have been used as exchange rate movement indicators. However, it has not be proven how economic determinants can be used to predict the exchange rate of countries having the same inflation levels. Economists have always been looking for ways to predict exchange rate movement and eliminate the uncertainties associated with it. According to research, the exchange rate is considered to be similar to fiscal assets. The cost movement in the exchange rate is primarily elicited by adjustments in the prospects concerning conceivable economic fundaments instead of current changes. Therefore the available exchange rate prediction models do not exclusively have the capacity to accurately predict the exchange rate movements (Ryou & Terra, 2015). This essay is a discussion of why it is apparently difficult to forecast exchange rate by analyzing monetary models such as the Mundell-Fleming model and the Dornbusch model. Exchange rate movement is a critical element of global business and it should be looked into comprehensively to eliminate the uncertainty associated with it.

Throughout last decade, this monetary model was widely used all over the world to make important financial decisions. The model, however, lost approval among economists especially in the prediction of exchange rate movement because of several factors associated with this model. First of all, the Dornbusch model is not very significant in predicting exchange rate movements because such approximations cannot overcome modest forecast of no changes in the exchange rates and experimental proof are usually negative (Grauwe, 2014).  As much as the model can successively predict the simultaneous jump in temporary interest rates and also has the ability to increase the dollar rate, there is so many exchange rates movement that is totally not related to fundamental economics including the money supplies and government budgets (Blanchard, 2006). Even among the several variants associated with the Dornbusch model, none has the capability of modifying the model to produce a consistent forecast of exchange rate movements.

Analysis of Dornbusch Model

Secondly, using this model it is multifaceted to project the movements of exchange rate because of the several macroeconomics movements which are unequivocally concomitant with making the most of utility. This model has a coherent expectation that mainly focuses on descriptive asset estimations and market of goods and services. In the 1980s Keynesian theory brought up the concept of slow adjustment of price through the optimization of organizations but still, the microeconomics movements were mainly based on the neoclassical models that used adjustable prices (Ca’Zorzi, 2017). The Dornbusch model is difficult and complex to use in forecasting exchange movements because it has the aspect of loosening conditions including presetting prices while slow price changes are allowed.

The model also is commonly known to be related to the overshoot of nominal rates of exchange in the eventual equilibrium because of volatility in the economy and this is caused by money supply. This model suggests that markets are most likely going to fall into equilibrium after an economic shock and this is because of price adjustments or flexible exchange rates. However, there are disparities in this factor because, in the price adjustments, the changes are not risky and time consuming compared to the flexible exchange rates. This model is generally not appropriate to use for forecasting exchange rate movements because of the three variables α, θ and β are likely to change at any given period of time. Also it is not clear how long the exchange rate can take to fluctuate because of the long-run equilibrium hence the model cannot precisely predict when the overshoot can end.

The Mundell-Fleming model was made from another monetary model known as the IS-LM model which brought out concepts to help economists understand the movement of exchange rates. The IS-LM model is usually applied in evaluating the impact of fiscal and monetary policies and it is associated with several markets such as money, assets and goods. This model is based on the assumption that there are no restrictions as far as movements of capital are involved.  The model is usually expressed as shown below.

Y = C(Y) + I (i) + G + NX(Y, S)

L(Y, i) = M/P

BoP = CA + KA

Where;

Y denotes actual income

C denotes household expenses that basically rely on the actual income

I denote investment that is negatively related to the interest rate of a nation

Analysis of Mundell-Fleming Model

G represents the government expenditure

NX denotes the net profits that rely on actual income as well as negatively related to exchange rate.

The model cannot precisely forecast the movements in exchange rate because its prediction techniques are not in accordance with the monetary policy, fiscal policy and the adjustments in payment balance. The model is also miscellaneous since independent variables should be predicted in forecasting the rates of exchange movements and the data should have a similar periodicity (Galí, 2015). Thirdly, this model is not suitable for predicting the movements in exchange rates because of its assumption to any alterations to exchange rate instantly after variations in macroeconomic variables.

It is challenging to use the Mundell-Fleming model to forecast the movements in exchange rates because the model mainly focuses on the independence of fixed exchange rates, capital policy and the monetary policy. These three cannot be concurrently realized therefore making the model complex in predicting the movements in exchange rates.  The model suggests that if the capital mobility has fixed the exchange rate then the nation has no capability of sustaining the monetary policy independence (Fred, 2017). However, this assumption is not applicable to small nations and it is also not true when we consider large nations that have the ability to ensure capital control and the independence of the monetary policy. Additionally, the monetary model foresees that the exchange rate is sturdily related to the monetary supply degree making the monetary policy not important. Besides, if fiscal control, equilibrium and inflation are not controlled appropriately the devaluation may become worse. This can also occur if a self-reward bubble is generated by the asset markets (Moosa, 2013). On the other hand, if the economy is expressively dependent on the re-export manufacturing sector then the current account devaluation can be decreased.

The monetary model suggests that leads to the long-run association because the purchasing power parity (PPP) within a given time frame always remains constant. Monetary model is not that complex but it fails in allowing the assessment impacts of fiscal policy on exchange rate movements. The monetary model is, therefore, cannot precisely forecast exchange rate movements because the model fails to define the volatility that is associated with the exchange rate (Brunnermeier& Sannikov, 2017). The model also assumes that the exchange rates simultaneously adjust to the changes in the macroeconomic variables but this does not occur in reality.

The monetary model suggests that monetary policies are used in the overshoots of the exchange rate and the long run equilibrium.  The monetary, therefore, does not adjust in according to macroeconomics hence stickiness associated with product and service costs have to be compensated.  The interest rate, in reality, has to be determined by the PPP and the relative money supply as well. .The short time value of a currency is completely dissimilar from the eventual rate of equilibrium; though, the previous varies centered on the second in the occasion that product and service costs attain new equilibrium (Haidar, 2011).  The monetary model cannot forecast the exchange rate movements because overshoot delay may occur but the undershooting may not follow the predicted exchange rate (Feuerriegel, Wolff & Neumann, 2015). The model successful demonstrates the movements in the exchange rate but fails to predict these fluctuations.

Conclusion

Exchange rate movement is a common phenomenon in global business and it is associated with depreciation, appreciation, devaluation or revaluation. The monetary, Mundell-Fleming and Dornbusch models cannot effectively predict the exchange rate movements.  The Dornbusch model cannot overcome unpretentious prediction of no changes in the exchange rates and experimental proofs are usually negative. Furthermore, Mundell-Fleming model focuses on imaginative estimations of asset market whereas in the monetary model the exchange rate exceeds the eventual equilibrium is expansionary monetary policies are used (Rey, 2015). Therefore, this is why it is apparently difficult to forecast exchange rate.

References

Blanchard, Olivier 2006. Macroeconomics (4th ed.), Upper Saddle River, NJ: Prentice Hall.

Grauwe, P. D., & Dewachter, H. (2014). Chaos in the Dornbusch model of the exchange rate. In Exchange Rates and Global Financial Policies (pp. 3-32).

Brunnermeier, M. K., & Sannikov, Y. (2017). International Monetary Theory: Mundell-Fleming Redux. Technical Report, Princeton University.

Ca’Zorzi, M., Koci?cki, A., & Rubaszek, M. (2015). Bayesian forecasting of real exchange rates with a Dornbusch prior. Economic Modelling, 46, 53-60.

Feuerriegel, S., Wolff, G., & Neumann, D. (2015). Information processing of foreign exchange news: Extending the overshooting model to include qualitative information from news sentiment.

Fred, Y. Y. (2017). A probe into the unification of micro-macro-economics: Arrow-Debreu-Mundell-Fleming model as a standard model. In Scientific Metrics: Towards Analytical and Quantitative Sciences (pp. 85-94). Springer, Singapore.

Galí, J. (2015). Monetary policy, inflation, and the business cycle: an introduction to the new Keynesian framework and its applications. Princeton University Press.

Haidar, J. I. 2011. Currency Valuation and Purchasing Power Parity. World Economics, Vol. 12, Issue 3, pp. 1-12.

Harvey, J. T. 2005. Post Keynesian versus Neoclassical Explanation of Exchange Rate Movements: A Short Look at the Long Run. Pp. 1-27.

Moosa, I., Burns., K., 2013. The monetary model of exchange rate is better than the random walk out-of-sample forecasting. Applied Economics Letters, Vol. 20, Issue 14, pp. 1293-1297.

Rey, H. (2015). Dilemma not trilemma: the global financial cycle and monetary policy independence (No. w21162). National Bureau of Economic Research.

Ryou, H., & Terra, C. (2015). Exchange rate dynamics under financial market frictions. Korea: ESSEC Business School.