The government will intervene in the money market to prevent the currency from obviously deviating from an unsatisfactory level. The intervention of the central bank in the money market usually has a significant but temporary impact on the foreign exchange market. The central bank can unilaterally buy/sell its own currency in another country's currency, or intervene with other central banks to achieve more remarkable results. Alternatively, some countries can simply influence currency changes by hinting or threatening to intervene.
The basic theory of fundamental analysis
Purchasing power parity
Purchasing power parity theory stipulates that the exchange rate is determined by the relative prices of the same group of commodities. Changes in the inflation rate should be offset by changes in the exchange rate of the same amount but in the opposite direction. Take hamburgers as an example. If a hamburger is worth $2.00 in the United States and $ 1.00 in Britain, then according to the purchasing power parity theory, the exchange rate must be $2 per 1 dollar. If the prevailing market exchange rate is $65,438 +0.7 per pound, then the pound is called an undervalued currency and the dollar is called an overvalued currency. This theory assumes that these two currencies will eventually become 2: 1.
The main deficiency of purchasing power parity theory is that it assumes that goods can be traded freely and does not include transaction costs such as tariffs, quotas and taxes. Another disadvantage is that it only applies to goods, but ignores services, which may have a very obvious value gap. Besides the difference between inflation rate and interest rate, there are several other factors that affect the exchange rate.
Interest rate parity (IRP)
Interest rate parity stipulates that the appreciation (depreciation) of one currency against another will be offset by the change of interest rate difference. If the American interest rate is higher than the Japanese interest rate, then the dollar will depreciate against the Japanese yen, and the extent of depreciation depends on preventing risk-free arbitrage. The future exchange rate will be reflected in the forward exchange rate stipulated on that day. In our example, the forward exchange rate of the US dollar is regarded as a discount, because the yen bought at the forward exchange rate is less than the yen bought at the spot exchange rate. The yen is regarded as a premium.
After 1990s, there is no evidence that rate parity is still effective. Contrary to this theory, a currency with high interest rate usually does not depreciate, but appreciates because it has suppressed inflation for a long time and is an efficient currency.
Balance of payments model
The model holds that the foreign exchange rate must be at its equilibrium level-that is, the exchange rate that can produce a stable current account balance. Countries with trade deficits will reduce their foreign exchange reserves and eventually devalue their currencies. Cheap currency makes the country's goods more competitive in the international market, and at the same time makes imported products more expensive. After a period of adjustment, the import volume was forced to decline and the export volume increased, thus stabilizing the trade balance and currency to a balanced state.
Like the purchasing power parity theory, the balance of payments model mainly focuses on traded goods and services, ignoring the increasingly important role of global capital flows. In other words, money pursues not only goods and services, but also financial assets such as stocks and bonds in a broader sense. This capital flows into the capital account of the balance of payments, thus balancing the deficit of the current account. The increase of capital flow produces the asset market model.
Asset market model
The rapid expansion of financial assets (stocks and bonds) makes analysts and traders look at money from a new perspective. Economic variables such as growth rate, inflation rate and productivity are no longer the only driving forces of currency change. The share of foreign exchange transactions derived from transnational financial assets transactions dwarfs the currency transactions derived from trade in goods and services.
The asset market approach regards money as the price of assets traded in an efficient financial market. Therefore, money increasingly shows its close relationship with the asset market, especially the stock market.