It is said, “A currency’s value mirrors the fundamental strength of its underlying economy, relative to other economies. ” A situation is given to determine the exchange rate of the Mexican Peso (MP) against the US Dollar at the end of 2008. The exchange rate derived is MP9. 5 = $1. The formula used to determine this rate is by subtracting the Real Exchange Rate (MP0. 84/$) from the Spot Rate (MP10. 4/$). You can get the Real Exchange Rate by using this formula: “(1+US inflation rate) / (1+Inflation rate difference of the two countries) (1+Mexico inflation rate).
” So the values given were put into the formula: (1+. 03) / (1+. 09) (1+. 12). The method used here is the “Purchasing Power Parity and Exchange Rate Determination (PPP). ” (Eun, C. S. et al. Ch 5. slide 21). Notice that the real exchange rate is less than 1. According to PPP, if the real exchange rate is less than 1, “competitiveness of domestic country improves with currency depreciations. ” Notice, too that the difference of inflation rate between Mexico and US is 9%. This means that MP should depreciate by 9%.
This method, isn’t used alone to determine a nation’s economic stability. (Eun, C. S. et al. Ch 5. slide 21 & 22). In forecasting the exchange rate, the Technical Approach studies the “patterns and previous history,” that “history repeats itself,” while the Efficient Markets Approach says the “exchange rate will only change when new information arrives. ” Both theories can help in determining the future exchange rate, but current data tells more and done by the Efficient Markets Approach that’s why its forecasts are “unbeatable. ” (Eun, C.S. et al. Ch 5. slide 27 & 28).
The results of empirical data are the basis of “currency trader’s expectations about the future value of the peso. ” (Eun, C. S. et al. Ch 2. slide 28). Works Cited Eun, C. S. , Resnick, B. G. 2001. International Financial Management 2nd ed. Chapter 2. The McGraw-Hill Companies. [http://www. mhhe. com/business/finance/er2e/ppt. mhtml] Eun, C. S. , Resnick, B. G. 2001. International Financial Management 2nd ed. Chapter 5. The McGraw-Hill Companies. [http://www. mhhe. com/business/finance/er2e/ppt. mhtml]