In macroeconomics about exchange rate, scholars usually use two methods, namely, balance of payments method and asset method. The former thinks that the exchange rate is the result of the trade of goods and services between countries, so the adjustment of exchange rate makes the trade of goods tend to be balanced. The latter thinks that the adjustment of goods and services is too slow to reflect in time, and the exchange rate adjustment makes the international financial assets transaction tend to be balanced.

1 balance of payments method

There are two most important contents in the balance of payments: current account and capital account. Import and export transactions involving goods and services are recorded directly in the current account, while the capital account records the international trade transactions of all assets.

In the law of balance of payments, international trade determines the exchange rate, because the demand for foreign currency depends on the domestic demand for foreign goods, and the supply of foreign currency depends on the foreign demand for domestic goods and services, so the intersection of the two determines the exchange rate (as shown):

As shown in the figure, the exchange rate reaches equilibrium at S*. If the exchange rate is greater than S*(Sh), it means that the balance of payments is a surplus at this time, and vice versa (Sl).

To sum up, the increase (decrease) of imports will increase (decrease) the demand for money in importing countries, while the increase (decrease) of exports will increase (decrease) the supply of money in importing countries. If supply exceeds demand, foreign currency will depreciate, and if supply is less than demand, foreign currency will appreciate.

Among the factors that affect a country's import and export, inflation rate and real national income are the two main reasons. For example, if a country is suffering from inflation, prices will go up. If the money supply increases at a given total output level, the exchange rate will rise in the short term, but in the long run, the exchange rate will stimulate exports and increase output, thus increasing the demand for money, and the exchange rate will fall. But it is still higher than the initial exchange rate, so it is not difficult to see that the exchange rate is positively related to inflation.

The increase of real national income will promote domestic consumption and increase imports, thus increasing the demand for foreign currency and exchange rate. On the other hand, the increase in the real income of foreign residents will also promote foreign consumption, thus increasing foreign imports and domestic exports, thus increasing the demand for local currency, and the exchange rate will fall.

2 asset law

Scholars who apply the asset method believe that the exchange rate is determined in the foreign exchange market, so the exchange rate is not only a simple change in the demand for goods and services, but also includes investors' expectations for the future. According to the purchasing power evaluation theory, the exchange rate is the relative price of goods between the two countries, so the exchange rate reflects the relative supply and demand changes of the two currencies.

Assuming that the domestic money supply increases and the currency depreciates, then prices rise. At the same time, due to the increase in supply, domestic interest rates have decreased. According to the exchange rate parity without hedging, the real exchange rate rises and the local currency depreciates.

In fact, the impact of the increase in money supply on commodities and financial markets is not overnight, and the two are interrelated. However, the reaction of financial market is indeed faster than that of commodity market, and the lag of commodity market determines that the change of exchange rate will not be a ride.

When the money supply increases, the basic process can be reflected in the following figure:

The money supply is sudden, and the speed of change is very fast, even others did not expect it, but this change was quickly reflected in the financial market. For example, the interest rate dropped rapidly and the exchange rate suddenly rose. However, in the subsequent process, the interest rate is slowly rising, the exchange rate is slowly falling, and the overall price level is much slower and more stable.

3 the basic issues of exchange rate determination

No matter from the perspective of balance of payments or assets, the direct cause of exchange rate changes is the change of supply and demand, but this change of supply and demand is not only the financial market, but also the physical market, but a mixture of the two.

The exchange rate change in the direct financial market reflects people's expectation of the future exchange rate, which is based not only on the future trend of international trade, but also on the investment philosophy of every investor. At the same time, due to the uncertainty of expectations (which may be exaggerated or underestimated and rarely very accurate), spot exchange rate can only reflect future expectations, and expectations are usually inaccurate. Even if they are accurate, there is a lot of arbitrage space in the short term. Therefore, the process of exchange rate changes will not be smooth sailing, because people are changing and people are fickle.

But the actual and final exchange rate trend is still determined by international trade. Because foreign exchange will eventually play a role in the transaction, if there is no international trade, what is the exchange rate? Therefore, the decisive factor is the trend of international trade.

As long as we can firmly grasp the problem of supply and demand, it is not difficult to understand the exchange rate.