EXCHANGE RATE THEORIES

1
EXCHANGE RATE THEORIES

• Traditional theories
• more important in explaining exchange rate
  movements in the long run
• Trade flows or Elasticity Approach
• Purchasing power parity
• Modern exchange rate theories
• Focus on capital markets and international
  capital flows
• Explain short run volatility of exchange rate
• Tendency to overshoot the long run equilibrium
  level
• Monetary Approach
• Portfolio Balance Approach

2
EXCHANGE RATE THEORIES

• Trade / Elasticity Approach
• Based on flow of goods and service
• Equilibrium exchange rate is one that balances
  value of exports and imports
• Value of imports gt value of exports Trade
  deficit
• exchange rate domestic currency depreciate
  under flexible system
• Result Exports Imports until trade is balanced
• Speed of adjustment depends on responsiveness
  (elasticity) of imports and exports to price
  changes, thus known as ELASTICITY APPROACH
• If nation is at or near full employment a larger
  depreciation of currency required shift domestic
  resources to production of more exports and
  import substitutes than if nation has unemployed
  resources

3
TRADE / ELASTICITY APPROACH

• Instead, domestic policy required to reduce
  domestic expenditure to release domestic
  resources to produce more exports and import
  substitutes
• This emphases importance of trade / flow of goods
  services in determination of exchange rate
• International capital flows only to cover or pay
  for temporary imbalances
• Thus, Trade / Elasticity approach provides
  fundamental explanation of exchange rate
  determination in the long run

4
PURCHASING POWER PARITY

• PPP theory is more relevant in the long run
• Absolute version of PPP states exchange rate
  between two currency is the ratio of countries
  general price levels
• Example if and then exchange
  rate between and is
• PPP theory is based on implicit assumptions
• No transport costs, tariffs or other obstruction
  to free flow of trade
• All commodities are traded internationally
• No structural changes, war etc occur in either
  countries
• As these assumptions are not true, absolute
  version of PPP cannot be taken seriously
• Relative form of PPP is ok if price double in US
  relative to UK, exchange rate with respect to
  should double, to
• So long as no changes in above variables, changes
  in exchange rate is roughly proportional to ratio
  of two countries general price levels.

5
MONETARY APPROACH

• Exchange rate determined in the process of
  balancing stock or total demand and supply of
  national currency in each nation
• Money supply determined independently by monetary
  authority
• Demand for money depends on
• level of real income M
• General price level P
• Interest rate i
• Higher real income and prices, greater demand for
  money balance
• Higher interest, smaller quantity of money
  demand, as holding money results in greater
  opportunity costs than interest bearing assets,
  bonds etc.
• For a given M, and P, equilibrium i (interest
  rate) is given _at_ intersection of demand and
  supply curve for money

6
MONETARY APPROACH

• Suppose initially foreign exchange market is in
  equilibrium, i.e., at interest parity positive
  interest rate differential in favour of foreign
  country is equal to forward discount on foreign
  currency
• That is,
• If monetary authority in the home country
  increases money supply
• Proportionate increase in price levels in the
  home country in long run
• Depreciate home currency as indicated by PPP
• Example If US Federal reserve increase money
  supply by 10, and nothing change in UK, general
  price levels in US expected to rise by 10 and
  exchange rate rise ( depreciate against ) by
  10 from R2 to R2.20

MS
i
i
L
M
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MONETARY APPROACH

• This occurs slowly over time as commodity markets
  and prices respond sluggishly
• Increasing MS and resulting decline in i affect
  financial markets, and exchange rate immediately
• Decline in leads to increased US financial
  investment flow to UK
• Leads to immediate depreciation of , say 16,
  and exceeds or overshoots 10 depreciation of
  expected in long run as per PPP theory
• Later prices in US rise relative to UK overtime,
  and appreciate by 6 so as to remove exchange
  rate overshooting or excessive depreciation that
  occurs soon after US increased its MS

MS1
MS
i
MS
i
MS1
Increased demand for Money due to price rise
i2
L1
i
i
L
L
i1
i1
M
M
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PORTFOLIO BALANCE APPROACH

• Monetary approach appropriate in explaining short
  run exchange rate fluctuations, but failed to
  explain movements in exchange rate during
  floating period of 1973
• Monetary approach overstress role of money and
  under-emphasis role of trade as determinants of
  exchange rate in long run
• Monetary approach treats domestic and foreign
  financial assets are perfect substitutes, but
  actually they are not
• Thus, portfolio balance approach OR Asset Market
  model generally preferred
• Portfolio Balance Approach assumes
• Domestic and foreign bonds are imperfect
  substitutes
• Exchange rate is determined in the process of
  balancing stock or total demand and supply of
  financial assets (money is only one) in each
  country
• Brings trade explicitly into analysis
• Therefore, PBA is a more realistic and
  satisfactory version of monetary approach

9
PORTFOLIO BALANCE APPROACH

• Start from a position of portfolio or financial
  and trade balance
• Assume MS interest rate, and to a shift
  from domestic bonds to the domestic currency and
  foreign bonds
• Shift towards foreign bonds causes
• An immediate depreciation of home currency
• Depreciation stimulates nations exports and
  discourages imports
• Leads to trade surplus and appreciation of
  domestic currency
• Neutralize part of original depreciation
• Portfolio balance approach also explain
  overshooting by explicitly bring in trade into
  adjustment process in long run
• Conclusions
• Financial markets adjust to disequilibrium or
  clear faster than commodity markets
• Therefore, exchange rates are much more sensitive
  to capital market imbalances than to commodity
  market and trade imbalances
• Commodity market imbalances are critical
  determinants of medium and long run exchange rate
  trends

10
PORTFOLIO BALANCE APPROACH

• This approach has become centre piece of analysis
  of foreign exchange determination
• However, it does not provide complete and unified
  theory of exchange rate determination