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Unit 14: Currency/Forex Market

Where BCA represents the current account balance; BKA represents the capital account balance; Notes
and BRA represents the reserves account balance.

Real Interest Rate Differentiation Model

The Real Interest Rate Differential Model simply suggests that countries with higher real interest
rates will see their currencies appreciate against countries with lower interest rates. The reason
for this is that investors around the world will move their money to countries with higher real
rates to earn higher returns, which bids up the price of the higher real rate currency.
Asset Market Model

The Asset Market Model looks at the inflow of money into a country by foreign investors for the
purpose of purchasing assets such as stocks, bonds and other financial instruments. If a country
is seeing large inflows by foreign investors, the price of its currency is expected to increase, as
the domestic currency needs to be purchased by these foreign investors. This theory considers
the capital account of the balance of trade compared to the current account in the prior theory.
This model has gained more acceptance as the capital accounts of countries are starting to
greatly outpace the current account as international money flow increases.

Monetary Model
The Monetary Model focuses on a country’s monetary policy to help determine the exchange
rate. A country’s monetary policy deals with the money supply of that country, which is
determined by both the interest rate set by central banks and the amount of money printed by
the treasury. Countries that adopt a monetary policy that rapidly grows its monetary supply
will see inflationary pressure due to the increased amount of money in circulation. This leads to
a devaluation of the currency.
These economic theories, which are based on assumptions and perfect situations, help to illustrate
the basic fundamentals of currencies and how they are impacted by economic factors. However,
the fact that there are so many conflicting theories indicates the difficulty in any one of them
being 100% accurate in predicting currency fluctuations. Their importance will likely vary by
the different market environment, but it is still important to know the fundamental basis behind
each of the theories.

14.4.2 Economic Data

Economic theories may move currencies in the long term, but on a shorter-term, day-to-day or
week-to-week basis, economic data has a more significant impact.
It is often said the biggest companies in the world are actually countries and that their currency
is essentially shares in that country. Economic data, such as the latest gross domestic product
(GDP) numbers, are often considered to be like a company’s latest earnings data. In the same
way that financial news and current events can affect a company’s stock price, news and
information about a country can have a major impact on the direction of that country’s currency.
Changes in interest rates, inflation, unemployment, consumer confidence, GDP, political stability
etc. can all lead to extremely large gains/losses depending on the nature of the announcement
and the current state of the country.
The number of economic announcements made each day from around the world can be
intimidating, but as one spends more time learning about the forex market it becomes clear
which announcements have the greatest influence. Listed below are a number of economic
indicators that are generally considered to have the greatest influence – regardless of which
country the announcement comes from.

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