Question

Please explain why forecasting exchange rate movement is so difficult by using monetary model.

Answer 1

In standard economic models of the exchange rate such as the monetary model of exchange rate determination it is assumed that:

(1) all agents are perfectly informed.

(2) all agents use the same model, and

(3) they form their expectations consistent with the theoretical model structure.

Such assumptions are way to ideal for the real world scenario. There exists economic differences between countries—in such areas as national income, money growth, inflation and trade balances— which have long been considered critical determinants of currency values. Exchange rates are far more volatile than the economic fundamentals that supposedly determine them and are very difficult to replicate in a model without introducing arbitrary disturbances..