Forex Blog: Currency Trading News & Analysis.

June 25th 2007

How to Value a Currency

With the US government doggedly clinging to the notion that China is manipulating its currency and insisting that the communist country be punished accordingly, it bears asking “how can we determine that a currency (in this case the Yuan) is in fact undervalued, and if so, by how much.  One notable economist has laid out three general techniques for “valuing a currency,” which may prove useful to all of you amateur economists.

First, there is the concept known as “purchasing power parity,” which suggests that a pair of currencies should fluctuate in value relative to each other based on changes in their respective interest rates and inflation. Second, there is the notion of a “sustainable” or “fundamental equilibrium” exchange rate which brings a country’s current account into balance- neither deficit nor surplus.  Third, historical exchange rate data can be regressed against various economic indicators (productivity, employment, etc.) in order to distill the select few that had the most direct effect on the currency in the past. The most current economic data can then be plugged into the resulting equation and tested against actual exchange rates.  However, while economists agree that these techniques are the most theoretically sound, they ignore the fact that currencies today seem less tied to the laws of plain economics than they do to financial economics- capital flows.

Read More: Misleading misalignments

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