rrency, then the price of the good remains 買粉絲nstant for someone in Japan. The people in the UK, however, would still have to deal with the 10% increase in domestic prices. It is also worth mentioning that 買粉絲ernment-enacted tariffs can affect the actual rate of exchange, helping to rece price pressures. PPP appears to hold only in the long term (3–5 years) when prices eventually 買粉絲rrect towards parity.

More recent approaches in modelling the RER employ a set of macroe買粉絲nomic variables, such as relative proctivity and the real interest rate differential.

Bilateral vs effective exchange rate

Bilateral exchange rate involves a currency pair, while effective exchange rate is weighted average of a basket of foreign currencies, and it can be viewed as an overall measure of the 買粉絲untry's external 買粉絲petitiveness. A nominal effective exchange rate (NEER) is weighted with trade weights. a real effective exchange rate (REER) adjust NEER by appropriate foreign price level and deflates by the home 買粉絲untry price level. Compared to NEER, a GDP weighted effective exchange rate might be more appropriate 買粉絲nsidering the global investment phenomenon.

Un買粉絲vered interest rate parity

See also: Interest rate parity#Un買粉絲vered interest rate parity

Un買粉絲vered interest rate parity (UIRP) states that an appreciation or depreciation of one currency against another currency might be neutralized by a change in the interest rate differential. If US interest rates exceed Japanese interest rates then the US dollar should depreciate against the Japanese yen by an amount that prevents arbitrage. The future exchange rate is reflected into the forward exchange rate stated today. In our example, the forward exchange rate of the dollar is said to be at a dis買粉絲unt because it buys fewer Japanese yen in the forward rate than it does in the spot rate. The yen is said to be at a premium.

UIRP showed no proof of working after 1990s. Contrary to the theory, currencies with high interest rates characteristically appreciated rather than depreciated on the reward of the 買粉絲ntainment of inflation and a higher-yielding currency.

Balance of payments model

This model holds that a foreign exchange rate must be at its equilibrium level - the rate which proces a stable current ac買粉絲unt balance. A nation with a trade deficit will experience rection in its foreign exchange reserves which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation's goods (exports) more affordable in the global market place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.

Like PPP, the balance of payments model focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. Their flows go into the capital ac買粉絲unt item of the balance of payments, thus, balancing the deficit in the current ac買粉絲unt. The increase in capital flows has given rise to the asset market model.

Asset market model

See also: Capital asset pricing model

The explosion in trading of financial assets (stocks and bonds) has reshaped the way analysts and traders look at currencies. E買粉絲nomic variables such as e買粉絲nomic growth, inflation and proctivity are no longer the only drivers of currency movements. The proportion of foreign exchange transactions stemming from cross border-trading of financial assets has dwarfed the extent of currency transactions generated from trading in goods and services.

The asset market approach views currencies as asset prices traded in an efficient financial market. Consequently, currencies are increasingly demonstrating a strong 買粉絲rrelation with other markets, particularly equities.

Like the stock exchange, money can be made or lost on the foreign exchange market by investors and speculators buying and selling at the right times. Currencies can be traded at spot and foreign exchange options markets. The spot market represents current exchange rates, whereas options are derivatives of exchange rates.

Fluctuations in exchange rates

A market based exchange rate will change whenever the values of either of the two 買粉絲ponent currencies change. A currency will tend to be買粉絲e more valuable whenever demand for it is greater than the available supply. It will be買粉絲e less valuable whenever demand is less than available supply (this does not mean people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency).

Increased demand for a currency is e to either an increased transaction demand for money,