Modern Theories of Exchange

Rates
Monetary Theories of Exchange Rates
 Modern Theories of Exchange Rates
• According to the modern theories that elaborate on
short-term exchange rate volatility, the international
capability and the supply and demand of financial
assets determine the divergence between the
purchasing power parity and the exchange rate. These
theories consider two factors:
– The short-term role of the capital markets
– The long-term influence of the commodity markets
• Since the expectations for a higher future monetary
increase are raised when the domestic money supply
rises, then the latter is the major driver of exchange
rate volatility.
 Monetary Approach – Flexible Exchange rates

• Under flexible exchange rates BoP are

corrected automatically moving exchange
rates- without inflow/outflow
• Occurs via change in prices
• Excess Ms, leads to depreciation of the
currency then P rises, to absorb excess money
supply.
• Excess supply of forex leads to appreciation,
and decline in price level
• Exchange value is purely determined by rate of
money growth and Income.
 Current account monetary model
• Assumptions
– Only one asset: money
– PPP holds
– Foreign price level is exogenously determined
– Foreign real income and interest rate are
exogenous
– Each country has stable demand function of
money.
– the exchange rate system is fully flexible so that
the balance of payment is continuously in
equilibrium, so that changes in reserves do not
take place.
 Demand function for real balance
• The Demand function for real balance is
given by RBd = f (y, i)
Where
– RBd = Demand for real balance
– Y = real income
– i = interest rate
 The Current account monetary
model
• F = k + (Md – Mf) – Q(Yd - Yf) + λX(id- if)
Where
– F is the exchange rate
– Md & Mf are the money supply in the domestic and
foreign economies.
– Yd & Yf are the real income in the domestic and foreign
economies
– id & if are the interest rate in the domestic and foreign
economies
 Working of the model
• If Md increases, people will try to get rid of
this excess money supply by purchasing
goods from domestic market and import.
• Md ↑→import ↑ →domestic price level ↑
→current A/c deficit ↑ domestic currency
depreciation↑→ export ↑
 Working of the model
• Md > Mf : Domestic currency will depreciate
• Yd > Yf : Domestic currency will appreciate
• Id > if : Domestic currency will appreciate

• Weakness of the model:

– The model does not allow departure from
PPP in short run
– Changes in interest rate may not
compensate the inflationary expectation
because of tight monetary policy
 The Capital account monetary
model
• Assumptions:
– PPP holds in the long run
– Stable demand function for both the
economies.
– Expected change in the interest rate in the
short run depends on the perceived departure
from long run equilibrium exchange rate and
inflation rate differentials. overshoot
 The Capital account monetary model

• F = K+(Md – Mf)–Q(Yd - Yf)+λ(id- if)+B{E(πd)–E(πf)}

Md > Mf : Domestic currency will depreciate

Yd > Yf : Domestic currency will appreciate
Id > if : Domestic currency will appreciate
πd>πf : Domestic currency will depreciate
• Suppose the forex market is in equilibrium
or at interest rate parity, then the positive
interest differential in favour of the foreign
 Portfolio Balance Model and Exchange Rates
• Asset Market Approach differs from Monetary
approach as it assumes that domestic and foreign
bonds are imperfect substitutes.
• Also differs by asserting that exchange rate is
determined in the process of equilibrating or balancing
the stock or total demand and supply of financial
assets (of which money is the only one) in each
country.
• Individuals and firms hold wealth in domestic bonds,
domestic money and foreign bonds denominated in
foreign currency.
• Incentive to hold bonds results from interest rate and
risk.
 Portfolio Balance Cont
• Opportunity cost of holding domestic money is the
foregone interest
• Individuals therefore hold either bonds or money
depending on interest and risk aversion.
• Higher the interest the smaller the money holdings
• Choice has to be made between holding domestic
money, domestic bond and foreign bond
• Foreign bond imposes an exchange rate risk
through depreciation of currency leading to capital
loss.
• It also allows for spread of risk between domestic
and foreign money
 Portfolio Balance Cont
• Therefore a financial portfolio will hold domestic money,
domestic bond and foreign bond.
• Given a holder’s taste, preferences, wealth, level of
domestic and foreign interest rates, expectations as to the
future value of currency, rates of inflation at home and
abroad- then individuals choose a portfolio that maximizes
their satisfaction.
• An increase in foreign interest will prompt immediate
purchase of foreign bonds, this exchange rate increases
• If domestic interest rates fall results in fall in exchange rate.
• Increase in wealth increases demand for money, domestic
and foreign bonds- purchase of foreign currency increases
in value.
 The Portfolio Approach
• The portfolio approach expands the
monetary approach by including other
financial assets.
• The portfolio approach postulates that the
exchange value is determined by the
quantities of domestic money and
domestic and foreign financial securities
demanded and the quantities supplied.
 The Portfolio Approach
• Assumes that individuals earn interest on
the securities they hold, but not on money.
• Assumes that households have no
incentive to hold the foreign currency.
• Hence, wealth (W), is distributed across
money (M) holdings, domestic bonds (B),
and foreign bonds (B*).
 The Portfolio Approach
• A domestic household’s stock of wealth is
valued in the domestic currency.
• Given a spot exchange rate, S, expressed
as domestic currency units relative to
foreign currency units, a wealth identity
can be expressed as:
W ≡ M + B + SB*.
 The Portfolio Approach
• The portfolio approach postulates that the
value of a nation’s currency is determined
by quantities of these assets supplied and
the quantities demanded.
• In contrast to the monetary approach,
other financial assets are as important as
domestic money.
 An Example
• Suppose the domestic monetary authorities
increase the monetary base through an open
market purchase of domestic securities.
• As the domestic money supply increases, the
domestic interest rate falls.
• With a lower interest, households are no longer
satisfied with their portfolio allocation.
• The demand for domestic bonds falls relative to
other financial assets.
 Example - Continued
• Households shift out of domestic bonds.
• They substitute into domestic money and foreign
bonds.
• Because of the increase in demand for foreign
bonds, the demand for foreign currency rises.
• All other things constant, the increased demand
for foreign currency causes the domestic
currency to depreciate.
 Spot Exchange Rate
Domestic currency units/foreign currency units

SFC
foreign exchange rate

S2
S1

DFC ’
DFC

Q1 Q2 Quantity of
foreign currency.
 Portfolio
• Accordingly exchange rate is determined
by equilibrium in each financial market.