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I am interested in knowing more about the valuation of a currency, and how the currency is determined to be 'overvalued' or indeed 'undervalued' in a floating/flexible exchange rate system.

More specifically, in a flexible exchange rate system: what is the currency over/undervalued against, and what role does inflation play in the definition?

Best,

Andrew

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Not sure what level of answer you're expecting, but here's an intuition. In equilibrium, countries should have balanced trade. That is, imports equals to exports.

If a country consistently exports more than it imports, the demand for its currency should make the currency appreciate (relative to other currencies). The country's currency would appreciate until its exports are not as competitive, driving down the trade balance and current account.

Likewise, if a country's CA is negative, then the low demand for that country's currency would make the currency depreciate, and it would be able to export more.

By looking at the country's current account, you could "estimate" if the currency is overvalued (should depreciate in the future... if CA is negative) or undervalued (should appreciate in the future... if CA is positive).

This is just the gist of the argument. More considerations need to be put in each country's characteristics such as demography, development status, etc. The IMF (with much criticisms from some of its member countries) issues what's called the External Balance Assessment (EBA) which serves as a "benchmark" of whether it thinks a given currency is over/undervalued. To be sure, some argue that this is somewhat political as the USTR sometimes point to this as a basis for putting some countries on the "watchlist" for being a currency manipulator. Be sure to read the list of caveats and disclaimers of the EBA though.

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  • $\begingroup$ Thank you Art. Great answer. $\endgroup$ – Andrew Coyle Sep 20 at 13:25

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