Three Models Of Exchange Rate Determination Economics Essay


It is in the involvement of a assortment of parties to understand the determiners of exchange rates. For economic experts, it is for their rational and academic chase to bring out the economic mechanism finding exchange rates. Policymakers would wish to understand the impacts and effects of exchange rates to the policies and frailty versa. Finance directors would wish analyze the cardinal factors finding exchange rates and integrate these factors in their fiscal or investing determination devising. Speculators in foreign exchange market would wish to cognize the way of exchange rate motion aforehand to do net income. In the undermentioned, we explain three theoretical accounts of exchange rate finding, viz. , the buying power para ( PPP ) , the pecuniary theoretical account and the portfolio balance theory.

Buying Power Parity

The theoretical premise of Buying Power Parity starts from the Law of One Price. The Law of One Price in unfastened economic system provinces that, if the market is competitory, no dealing cost and no barriers of trade, so indistinguishable merchandises in different states should be sold at the same monetary values, adjusted by exchange rate, i.e. under the same currency denomination. Otherwise, there is arbitrage chance. In notation,

pi =spi* ( 1 )

for pi = monetary value of good I at place state, pi*= monetary value of good I at foreign state, s = exchange rate

For illustration, the monetary value an ounce of gold quoted at London in GBP should be the same as an ounce of gold quoted at New York in USD times exchange rate of GBP/USD.

Following, we consider a theoretical account with two states. Both of them have the floating exchange rate-regimes and Law of One Price holds for all goods in the two counties. Then, the general monetary value degree of place state is should be the same as the general monetary value degree of foreign state, adjusted by exchange rate. In notation,

P=sP* ( 2 )

for P= general monetary value degree at place state, P*= general monetary value degree at foreign state

P and P* , the general monetary value degree is the leaden norm of all monetary values of goods. So if ( 1 ) holds for all goods, ( 2 ) will holds. ( 2 ) is what we called the absolute Buying Power Parity ( absolute PPP ) : the general monetary value degree of every state should be the same if adjusted to the same currency. In other words, the exchange rate should be determined by the comparative monetary value degree of two states. If you can utilize $ 1 of place currency to purchase a basket of goods at place state, so the $ 1 converted to foreign currency should be able to purchase the same basket of merchandises in foreign state, i.e. they have the same buying power.

We can construe that PPP is a long-term equilibrium degree of exchange rate that there is fundemental force of demand and supply in goods market to retain it. For illustration, assume that the domestic monetary value degree is higher than the foreign monetary value degree under the same currency step, i.e. P & gt ; sP* . If goods are indistinguishable and there is dealing cost and barriers of trade, so consumers from domestic state will non purchase local merchandises. They will utilize their domestic currency to interchange to foreign currency to purchase foreign merchandises, which is cheaper. The force of supply and demand of currency will drives down exchange rate to deprecate. In bend, depreciation of exchange rate will take down the monetary value of domestic merchandises ( under the same currency step ) and so the PPP equilibrium, P = sP* is retained.

Yet the absolute PPP to be excessively rigorous, economic experts considers a weaker signifier, called the comparative PPP. It states that per centum alterations in monetary value degrees of two states determine the per centum alteration in exchange rate. In notation,

I”P/P = I”s/s +I”P*/P* ( 3 )

The comparative PPP is a weaker signifier of absolute PPP because if absolute PPP holds true, the comparative PPP holds true besides but non frailty versa. Furthermore, alteration in monetary value degree is so the rising prices rate. The comparative PPP implies that exchange rate should be adjustedI”e/e to the difference between two states ‘ rising prices rates. For illustration, a state with hyperinflation should meet significant depreciation in its currency.

Empirical Support

The Purchasing Power Parity states that comparative monetary value degree is a cardinal determiner of exchange rate. An empirical trial would wish to see whether there is such a relationship in historical informations. The PPP hypothesis has be tremendously and extensively tested through empirical observation by economic experts. The extended trials by economic experts found really small empirical support to PPP. Exchange rate and the comparative monetary value degree are unrelated in short tally and medium tally. In the long tally, consequences found that exchange rate would meet to the theoretical equilibrium value from PPP, but at a really slow rate.

At the first glace, PPP seems to be a excessively rigorous hypothesis that it ‘s premise is improbable to keep. In world, there is dealing cost and barriers of trade. The general monetary value degrees so include non-tradable goods and different states have different constituents in their general monetary value degree. These divergences of the theoretical PPP will do the domestic monetary value degree and foreign monetary value degree non converges, but retain at some deviated degree.

Literature Review

Officer ( 1982 ) contains a elaborate sum-up on the theoretical and empirical plants on PPP at early phase. Rogoff ( 1996 ) provides a more update study on PPP and their empirical trials. Taylor & A ; Taylor ( 2004 ) uses more complete informations and more powerful econometric trials, as they describe, retain likewise consequence as old bookmans.

Monetary theoretical account

As exchange rate is the comparative monetary value of two currencies, it is sensible to see the supply and demand of money be an of import determiner of exchange rates. Introduction of money supply and money demand, two really cardinal macroeconomic variables, into our theoretical accounts

The pecuniary attack remainders on the measure theory of money in macroeconomics. First, Money supply ( Ms ) is a measure determined by the cardinal bank. In the measure theory, money is for the intent of medium of exchange. Money demand of an economic system is straight relative to the general monetary value degree and besides the measure of existent end product. For illustration, if the general monetary value degree is doubled, so the economic system would necessitate dual sum of money for their minutess. The same thought holds for measure of existent end product. Then,

Md = kPy ( 4 )

Where Md is money demand, P is the monetary value degree, Y is the existent end product and K is the speed of money. In equilibrium, Money supply must be equal money demand, and so:

Ms = kPy ( 5 )

By rearranging, we have

P= Ms/ky ( 6 )

By this signifier, we can construe that given a degree of existent end product of the economic system and a given degree of money supply determined by the cardinal bank, the monetary value degree of the economic system will be adjusted to Ms/ky.

Let * denotes the foreign currency variables. We assume the measure theory of money holds true to foreign state besides. We have

Ms*= k*P*y* ( 7 )

The 2nd of import premise of the pecuniary attack is that PPP holds true. The exchange rate ever attains its PPP equilibrium degree, as in ( 2 ) .

In the pecuniary attack, we have three relationships of variables now: the measure money of place state, quantity money of foreign state, and PPP. Uniting at that place three relationships and rearranging the three equations, we have:

Ms/ ky = S Ms*/ k*y* ( 8 )

The measure theory of money and PPP are two constructing blocks of the pecuniary attack. The PPP tells us that at the long tally equilibrium, the exchange rate should be equal to the ratio of place and foreign monetary value degree. The measure theory of money marcoeconomics describes that monetary value degree of a state is related to money supply of cardinal bank and existent end product of the economic system. Uniting them, the pecuniary attack concluded that exchange is determined by domestic and foreign money supply ( Ms & A ; Ms* ) , domestic and foreign existent end product ( y & A ; y* ) , and domestic and foreign speed of money ( k & A ; k* ) .

An of import deduction of the pecuniary attack is that cardinal bank ‘s money supply policy would hold primary impact to exchange rate.

Start with the domestic cardinal bank all of a sudden increase the money supply by a significant sum, with all other domestic and foreign variables maintain unchanged. The measure theory of money implies that the rise of money supply without addition in existent end product will drives up the domestic monetary value degree, which means rising prices besides. The addition in domestic monetary value degree will bring on domestic people to purchase more foreign merchandises and do the exchange rate to deprecate. This is the same equilibrating mechanism described in PPP.

We may see the magnitude of depreciation of currency by addition of domestic money supply. Harmonizing to equation ( x ) , exchange rate, s, is straight relative to Ms. So in the pecuniary attack, a given per centum addition in money supply will take to the same per centum of depreciation of currency.

A natural effect of the above analysis is to see if foreign money supply would take to what sort alteration of exchange rate. From equation ( x ) , we can see that foreign money supply Ms* comes into finding the exchange rate. If the foreign cardinal bank addition money supply, the foreign currency would deprecate as by our old analysis. Then, in bend, the domestic currency would appreciate comparatively.

On the other manus, we may see the consequence of an addition in existent end product on exchange rate in the pecuniary attack. Give a fixed degree of money supply, existent end product addition will take to heavy monetary value degree, as described in the measure theory of money. Then, on the unfastened economic system side, the exchange rate must appreciate, doing the local merchandises more expensive, to continue the PPP equilibrium. So we can reason that a rise in existent end product ( GDP ) will leads to grasp of the domestic currency, given other thing else changeless.

Empirical Evidence

The pecuniary attack is mostly based on PPP. Given the failure of PPP on empirical testing, it is non hard to conceive of that empirical trial on the pecuniary theoretical account of exchange rates should establish small support. Extensive trials have been carried out to analyze the relationship between exchange rate vs. money supply and exchange rate vs. existent end product. As representative, Frenkel ( 1976 ) and Meese & A ; Rogoff ( 1983 ) shows small empirical support on the Monetary attack.

Literature reappraisal

Johnson ( 1977 ) portrays a theoretical account intervention of the pecuniary theoretical account of exchange rates. Frenkel ( 1976 ) and Meese & A ; Rogoff ( 1983 ) are representative empirical plants on the pecuniary attack.

Portfolio Balance Model

In the pecuniary theoretical account, the planetary economic system is simplified as holding goods and money merely, and money is the medium of exchange to purchase domestic and foreign goods. Exchange rates are determined by the comparative demand and supply of money, domestic and foreign.

The portfolio balance theoretical account takes a farther measure from the pecuniary theoretical account that there are investing assets in the planetary economic system for people to keep. Peoples would see keeping money, domestic assets and foreign assets instead on their portfolio balance. Then the comparative demand and supply of these investing assets would find the exchange rate.

The portfolio balance theoretical account assumes there are three sorts of assets for people to apportion their entire wealth: Domestic money ( M ) , domestic bond ( B ) , and foreign bond ( FB ) . Domestic money ( M ) , pays no involvement, is a risk-free plus. In term of finance, the riskless rate is zero in this simplified theoretical account. Domestic bond and foreign bond are hazardous assets that payout with, with involvement rate rand r* severally. Then the existent involvement rate single receive from foreign bond is sr* .

The portfolio balance theoretical account of exchange rate makes farther premise in line with modern portfolio theory. Domestic bond and foreign bond are non perfect replacements. Keeping domestic and foreign bond together in the portfolio would cut down the unsystematic hazard. So people would non merely keep the bond with higher output merely, but hold a portfolio of domestic and foreign bonds. Furthermore, the persons, being are risk-averse and so they would keep some part of riskless plus, the money.

The persons have a entire wealth of W would make up one’s mind how to apportion them into money, domestic bond and foreign bond severally based on his hazard penchant and the returns of different assets, as in modern portfolio theory. He would buy more of one plus if the return of the plus addition, or if the return of the alternate assets lessening. In drumhead,

Demand of money = M ( R, sr* ) is diminishing in R and sr*

Demand of domestic bond = B ( R, sr* ) is increasing in R and decreasing in sr* .

Demand of foreign bond = FB ( R, sr* ) is increasing in sr* and decreasing in R.

Entire wealth, the supply of assorted assets, would be to the demand of assorted assets. , such that

W = M ( R, sr* ) + B ( R, sr* ) + BF ( R, sr* ) ( 9 )

It means that, in equilibrium, there would be some equilibrium value of R, r* and s to equilibrate demand and supply.

To concentrate on the function of exchange rate in this theoretical account, we may see R and r* as given to be stable by the bond markets and merely the exchange rate varies. The equation above can be simplified as:

W = M ( s ) + B ( s ) + BF ( s ) ( 10 )

Then, there will be a value of s to equalise the demand of assorted assets to entire wealth. In other words, the exchange rate is determined by the equilibrium across the money, domestic bond and foreign bond markets in this portfolio balance theoretical account.

Deductions and grounds of portfolio balance theoretical account

One of the most of import deductions from the portfolio balance theoretical account is that current history excess will be associated with depreciation of currency. Current history excess must be associated with capital history shortage, which means that the state is a net buyer of foreign assets. The demand of foreign bond addition and so exchange rate would deprecate for the equilibrium in plus markets to reconstruct.

However, as noted by Copeland ( 2008 ) , the trials of portfolio balance theoretical account, is far from satisfactory.

Literature reappraisal

Several articles by Branson propelled the portfolio balance theoretical account, and include empirical grounds besides. Branson ( 1983 ) provides a good history of sum-up.


We have reviewed three different theoretical accounts on exchange rates. The PPP, the most cardinal one, claims that monetary value degree is the cardinal determiner of exchange rates in the long tally. The market force of goods arbitrage would force the exchange rate to the equilibrium degree that balance the buying power of the different currency to the same degree. The pecuniary theoretical account incorporates the classical measure theory of money in marcoeconomics with buying power para. It predicts that money supply, determined by the cardinal bank, and existent end product are the determiners of exchange rate. The 3rd theory, the portfolio balance theoretical account extends the pecuniary theoretical account from sing the money market to the markets of a figure of assets. Persons demand each type of assets and exchange rate is determined as the equilibrium monetary value of assorted plus markets.

All of the theoretical accounts we discussed are laid on cardinal economic theory and are conceptually sound. Unfortunately, economic experts found small direct empirical support to these theoretical accounts.

We should non see rejecting these three theoretical accounts because of the deficiency of empirical support. First, these three theoretical accounts are conceptually cardinal and determine our believing in exchange rates. They will be highly utile when we extend our analysis with specifications in farther item and seek more specific deductions in exchange rate. Second, these theoretical accounts portray the long-term equilibrium behaviour of the exchange market. It is hard to see the volatile, second-to-second altering exchange rate market behaviour would be consistent with these theoretical accounts. There may be random dazes to the exchange rate market that systematically propel the exchange rate to travel in a random manner and so the long-term equilibrium of the theoretical accounts can non be attained.