Exchange Rate Determination

Three Theories of Exchange Rate

Balance of Payments Approach

This approach determines the exchange rate at which both the internal and the external economy are in equilibrium. Internal equilibrium in the economy reflects a state of full employment whereas external equilibrium implies equilibrium in the balance of payment.

Purchasing Power Parity (PPP) Approach

The PPP Approach is based on the law of one price. According to this law, goods that are identical in nature should be sold at the same price. The implication of this law is that the exchange rates should change in response to the price differentials that exist between countries.

 This approach is based on the assumption that economic agents can chose from a portfolio of domestic and foreign assets. The assets that can be in the form of money or bonds have an expected return. The arbitrage opportunity that is attached with this return determines the exchange rate.

Monetary and Portfolio Approach in the Determination of Exchange Rates

The BOP Approach

Theory and Application

The PPP Approach

Theory and Application

C. Comparison of the IRP, PPP, and IFE Theories

8.7

Interpretations of PPP
The absolute form of PPP, or the law
of one price, suggests that similar products in different countries should be equally priced when measured in the same currency. The relative form of PPP accounts for market imperfections like transportation costs, tariffs, and quotas. It states that the rate of price changes should be similar.

Suppose U.S. inflation > U.K. inflation. U.S. imports from U.K. and U.S. exports to U.K., so appreciates. This shift in consumption and the appreciation of the will continue until in the U.S., priceU.K. goods = priceU.S. goods, &
in the U.K., priceU.S. goods = priceU.K. goods.

Rationale behind PPP Theory

Derivation of PPP
Assume that initially home price index (Ph) and foreign price index (Pf) are equal and the exchange rate between the currencies of the two countries = 1. Let Ih = inflation rate in the home country If = inflation rate in the foreign country ef = % change in the value of the foreign currency

Due to different rates of inflation in the two countries they become unequal. Due to inflation home price index:

Derivation of PPP
Assume that initially home price index (Ph) and foreign price index (Pf) are equal and the exchange rate between the currencies of the two countries = 1. Let Ih = inflation rate in the home country If = inflation rate in the foreign country ef = % change in the value of the foreign currency

PPP implies: Pf (1 + If ) (1 + ef ) = Ph (1 + Ih )

Derivation of PPP
Since Ph = Pf , solving for ef gives:
ef = (1 + Ih ) 1 (1 + If ) If Ih > If , ef > 0 (foreign currency
appreciates)

If Ih < If , ef < 0
depreciates)

(foreign currency

If Ih = 5% & If = 3%, ef = 1.05/1.03 1 = 1.94%

Derivation of PPP
Therefore:
ef = 1 + Ih-1-If (1 + If )

ef

Ih

If

Suppose IU.S. = 9%, IU.K. = 5%. Then PPP suggests that e 4%.

Graphically

Comparison of Annual Inflation Differentials and Exchange Rate Movements For Four Major Currencies

8.3

Monetary and Portfolio Approach in the Determination of Exchange Rates

Monetary Approach
The Monetary Approach focuses on the supply and demand of money and the money supply process. The monetary approach hypothesizes that BOP and exchange-rate movements result from changes in money supply and demand.

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Small Country Model

Consider what happens if the central bank raises Money Supply. Money supply exceeds money demand. Inflation occurs. Exports fall and imports rise. There is pressure for the domestic currency to depreciate.

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The Portfolio Approach to Exchange-Rate Determination

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.
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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*).
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