Long run exchange rates are best explained by factors including real income differentials, inflation rate differentials, productivity changes and trade barriers. In the short run, exchange rates respond to real interest rate differentials, news about market fundamentals, and speculative opinion about future exchange rates.
True: An increase in the nominal interest rate would not necessarily cause a change in the exchange rate if the inflation rate were to increase by the same proportion, leaving the real interest rate unchanged. In this case, any increase in the return on a domestic asset would be offset by higher inflation in the domestic economy, leading investors to believe that the domestic currency will depreciate in the future as domestic goods become more expensive relative to foreign goods. Thus, only changes in real interest rates (i.e. the nominal interest rate changing by a different proportion than the inflation rate) are predicted to affect the exchange rate.
The simplest concept of purchasing-power-parity is the law of one price. It asserts that identical goods should be sold everywhere at the same price when converted to a common currency, assuming that it is costless to ship the good between nations, there are no barriers to trade, and markets are competitive. It rests on the assumption that sellers will seek out the highest possible prices and buyers the lowest ones. The purchasing-power-parity theory predicts that a country’s currency will depreciate by an amount equal to the excess of domestic inflation over foreign inflation. The theory also predicts that a country’s exchange rate will appreciate by an amount equal to the excess of foreign inflation over domestic inflation. The theory does not consider the impact of international capital movements, and it suffers from the choice of an appropriate price index used in price calculations. The law of one price holds reasonably well for globally tradable commodities such as oil, metals, chemicals, and some agricultural crops. The law does not appear to apply well to non-tradable goods and services such as cab rides, housing, and personal services like haircuts.
An overvalued currency tends to lead to a balance of payments deficit for the home country, while an undervalued currency leads to a balance of payments surplus. For example, a currency that is undervalued according to purchasing power parity is one in which domestic prices are lower than foreign prices, when expressed in a common currency. We would expect the domestic country to export more and import less, leading to a balance of payments surplus.
True: Over short periods of time, decisions to hold domestic or foreign financial assets play a much greater role in exchange rate determination than the demand for imports and exports does. According to the asset market approach to exchange rate determination, investors consider two key factors when deciding between domestic and foreign investments: relative interest rates and expected changes in exchange rates. Changes in these factors, in turn, account for fluctuations in exchange rates that we observe in the short run.
An exchange rate is said to overshoot when its short-run response (either depreciation or appreciation) to a change in market fundamentals is greater than its long-run response. Exchange rate overshooting occurs because exchange rates tend to be more flexible than other prices; exchange rates often depreciate/appreciate more in the short run than in the long run so as to compensate for other prices that are slower to adjust to their long-run equilibrium levels.
False: Most forecasters tend to use a combination of fundamental, technical, and judgmental analysis, with the emphasis on each shifting as conditions change. They form a general view about whether a particular currency is over or undervalued in a longer term sense. Within that framework, they assess all current economic forecasts, news events, political developments, statistical releases, rumors, and changes in sentiment, while also carefully studying the charts and technical analysis