This approach is based on the relative price of assets, specifically with the relationship between the relative price of domestic and foreign bonds and the exchange rate, where it is assumed that it ‘s supply and demand is affected by changes in monetary and/or fiscal conditions.
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Changes in national income affect both current and capital account, thus causing predictable reactions in the exchange rate in order to restore balance of payments equilibrium. Here’s a simple equation to show what I’m trying to explain here and is used in economics to show how economies adjust to changes in economic dynamics:

We can determine or predict exchange rates by analyzing interest rate differentials via a few principles. Assuming that the expected returns of a currency should be equalized through speculation in another country once converted back to the first currency, the theory of interest rate parity holds, where:
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According to PPP, exchange rates adjust to equalize tradable goods prices between countries. Therefore, if money supply rises, they’ll be more supply of money chasing too few goods. Thus, currency has to be depreciated to restore equilibrium. Also, as a result, there will be a reduction in interest rates as well.
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Sometimes known as the “law of one price”, Purchasing Power Parity (PPP) states that the price of a good in one country should equal the price of the same good in another country, exchanged at the current rate. Therefore, the exchange rate must move towards a long-term equilibrium value that ensures this is true. The formula is as follows:
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If we have a look at forex ads in the newspaper, there are many misleading advertisements that say that you don’t need to know anything about economics or the fundamentals of the foreign exchange market to be successful in forex. Obviously the contribution of economics to the field of currency analysis plays a huge role, especially in equilibrium exchange rate models, an important tool for analyzing long-term exchange rate trends where they basically give you the big picture of the foreign exchange market.
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U.S. Dollar (USD):

• World’s foremost reserve currency – used as a universal measure to compare values of any currency traded on Forex, but euro is a strong candidate to displace the dollar as the predominant reserve currency.
• Many of world’s currencies pegged against the dollar e.g. Chinese renminbi and Malaysian Ringgit until July 2005.
• Safe haven currency during international economic and political unrests (e.g. 1997/98 Southeast Asian Economic Crisis).

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In 1971, when floating exchange rates began to materialize, the foreign exchange (FOREX) market, a cash interbank market was established. This is where the currency of one country is exchanged for those of another and where international business settlements are made. The FOREX market grew to become so large, it is estimated that the daily trading volume average has exceeded US$2 trillion!

In the early days, the FOREX market was dominated by large international banks, huge companies, large funds, high net-worth individuals and so on but over the last decade or so, market maker brokers are allowed to break down the large interbank units and offer small traders the opportunity to buy or sell any number of these smaller units. Online forex trading has made it even easier for almost anyone who has the desire for greater returns and is fast gaining popularity as a solid diversification component in one’s financial portfolio.
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