Currency has a lot of academic theories around it. Parity condition is the main theory for economics in the forex. Parity condition explains the exchange price between two currencies that is based on factors like interest rates and inflation. Below are the other economic theories:
Purchasing Power Parity (PPP)
This theory states that after exchange rate adjustments, the price levels should be equal between two countries. The law of one price is the base of this theory where the price of a product should be the same around the world. Opportunity for arbitrage happens when a product has a large difference in cost between two products.
Interest Rate Parity (IRP)
Similar to PPP, it states that to remove arbitrage, similar interest rates should be constant in similar assets from two separate countries, while the risk is similar to each other.
International Fisher Effect (IFE)
This theory is about the appreciation of exchange rates between two countries based on the difference of their nominal interest rates.
Balance of Payment Theory
This theory focuses on accounts dealing with tangible good trades for the exchange rate directions. This measures the current and capital account of a country for the capital, inflow and outflow of a country.
Real Interest Rate Differentiation Model
This theory shows that the currency of a country with high real interest rate will appreciate against a country with low interest rates. This occurs as investors move money to a country with high real rates to gain high returns.
Asset Market Model
This model focuses on the money flow due to foreign investors purchasing assets like bonds or stocks. There will be an increase in currency price of a country if large amounts of foreign investors come in, as they would be required to purchase domestic currency of that country.
This looks at the monetary policy of a country to determine the exchange rate. The monetary policy of a country handles the supply of money that is determined by the number of printed money by the treasury and the interest rate by the central bank.
Countries are considered as large companies. Information and news about a country can impact its currency just like how current event,financial news and currency news trading can affect the stock price of a company. In forex, it is best to understand economic indicators to see the influences in the market.
These are the data pertaining to the number of people employed within a country or economy, usually released by most countries. A prosperous economy in a country can be seen in their strong employment growth and vice versa, though inflation can also occur with high employment.
These are the rates dictated by the central bank and are a big focus of those participating in the market as it is used to initiate the monetary policies of a country and adjust monetary supply.
This is the measure of the rise and fall of the level of prices over time. Inflation, which is the increase of prices, signifies the depreciation of currency in a country.
Gross Domestic Product
This is the measure of a country’s generated services and finished products over a period of time. GDP is used by foreign investors to measure the economic growth of a country. Investors are enticed with a country’s healthy economy.
This is the reflection of consumer spending, measuring retail sales over a certain period. Increased spending in a country signifies that the economy is strong.
These are long term goods that are requested and shipped measured over duration. The spending of individuals here indicates a healthy factory sector.
Trade and Capital Flows
The data from trade flow focuses on the import and export difference of a country, looking at the deficits when there are more imports over export.
The data from capital flows focuses on the inflow of currency by domestic currency sold to foreign investors and flow of investments to the country.
Combining these two give you the balance of payments which is split to three: the current account that monitors the movement of services and goods between countries, the financial account that focuses on the monetary investments between countries and the capital account that focuses on the monetary exchange to purchase capital assets between countries.