The Do’s and Don’ts of International Finance
Some absolutes and some falsehoods arise in the subject of international finance. You definitely need to know that macroeconomic fundamentals such as inflation rates, exchange rates, and growth rates affect the long-run changes in exchange rates. But you also must realize that short-term changes in the exchange rate don’t reflect the changes in fundamentals, although they may well reflect expectations of changes in those fundamentals.
This fact certainly motivates the use of foreign exchange derivatives to hedge against the foreign exchange risk in short-term transactions. In terms of the international monetary system, no perfect system exists. Alternative international monetary systems have their costs and benefits. Although a common currency area such as the Euro-zone sounds like a great efficiency-enhancing idea, it requires a great deal of policy coordination.
In terms of warnings, the fact that macroeconomic fundamentals cannot explain short-term changes in the exchange rate doesn’t mean that the theory of exchange rate determination is useless. The theory is helpful in determining the long-run changes in exchange rates.
Additionally, because most developed countries’ exchange rates are determined in foreign exchange markets, you don’t want to ignore policymakers. Monetary but also fiscal authority significantly affects exchange rates.
Finally, in terms of the international monetary system, exchange rates that don’t change or that change infrequently, as in the case of fixed or pegged exchange rates, don’t necessarily imply stability.