If you want to predict a future change of the conduction of rate of exchange it is advisable to determine the level of inflation in the near period. The more opened the economy is the larger degree all your forecasts will depend on the level of inflation.
In the broad sense, there are four basic approaches. The first and simplest method is to assume that in one year the exchange rate will remain the same as today. A similar "arbitrary" assumption is based on the fact that the probability of increasing the course is equal to the probability of its reduction. This fact does not impress much.
The second approach is based on the effectiveness of financial markets. We can suppose that the guaranteed American bond brings annual 5 percent, but the bond in pounds sterling gives annual 7 percent. Obviously, the market assumes that the aggregate profit of those and other bonds will be identical. Otherwise the interest rate on the bonds, whose joint income is expected lower, will rise to compensate losses.
The corresponding increase in the rate of exchange in which was designated a weak bond is expected potentially. The market attempts to make the aggregate profit or, as traders tell, to reach the unprovided percent ratio (UPR). It is much more reasonable than the first approach, but however this approach is not also suited as the prediction.
The sense of the third approach is a question what change in the exchange rate will be required to bring the economy into equilibrium more or less, moreover from the point of view of reaching steady pay balance. The vexed question is if such method of the fundamental-balanced exchange rate (FBER) is actually the good technology of prognostication or this is only the sequential attempt to accept desired for the real. In any case, forecasts made by means of the FBER are completely unimportant.
The fourth method is also based on the fundamental concept of equilibrium. The overall meaning consists in that the rates of exchange must move thus to equalize prices everywhere where the mechanism of their use operates. This method is based on the parity of buying attitude (PBA) but not on the incomes of the financial assets. It is possible to expect good extended forecasts from this method. In this case, it is worthwhile to combine this method with UIP. It is completely useless by short-term forecasts.
There is another method proposed by Sushil Vadhvanie, the official representative of the committee on the currency policy of the Bank of England. Specifically this committee determines the interest rates in England. Its method is based on the so-called model of intermediate period, which in the essence combines the UPR and FBER approaches.
According to this approach, changes in the rates of exchange reflect the difference in the interest rates and the specific insurance to the risk. The variables, which supporters of the UIP and FBER methods use, influence on the insurance.
The UPRFBER Method works completely properly and explains the exchange fluctuations in the larger degree, although its calculation formulas of the ratios between the currencies are sufficient "tenuous" from the statistical point of view. According to this method, all rates of exchange aim at the balanced level.
The variable of the difference of the interest rates plays less important role here than in the UPR. Special attention is here paid to the level of unemployment. The supporters of the FBER method do not consider it in their calculations. An increase in the level of unemployment decreases rate of exchange. Acting directly, it influences on the interest rates.
In any case, all this has much great significance than it would like. Thus, according to PBA and FBER, the exchange value of pounds sterling is considerably overstated relative to euro at the present time. UPR also predicts a drop of pounds sterling as a result of that the British interest rates are higher than European ones.
However, according to UPRFBER, pound sterling will possibly remain at the previous level as now. Its increase with respect to the German mark was caused only by an increase in the level of unemployment in Germany. Furthermore, it weakened the German stamp because it is considered that the basic condition of the current business account in Germany became worse. A similar situation prevents internal investments evidently.
The suppositional conclusion is that pounds sterling will remain strong. We want recall that any of these models cannot be used purely mechanically. There are many of other factors, influencing on the system, and it is impossible even theoretically to predict all them.