exchange rate determination model

7/31/2019 Exchange Rate Determination Model

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Md. Zahangir Alam

Assistant Professor of Finance

Department of Business Administration

International Islamic University Chittagong

Dhaka Campus

7/10/2012 [email protected]



According to the flexible price monetary modelthe price of a commodity is perfectly flexible.

As a result, the expected rate of inflationchanges due to change in the rate of nominal

interest. If the domestic rate of interest increases

compared to rate of foreign interest indicatesthat the value of the domestic currency

depreciated through the result of the inflationthat causes a lower demand of domestic currencyin comparison with foreign currency.

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Setting Assumption 1

The aggregate supply curve is vertical-Two points shouldbe remembered. First one is this does not imply thatoutput is constant and second one is a vertical supplycurve presupposes perfect price flexibility in all markets.

Assumption 2

The demand for real money balances is a stable functionof only a few domestic macroeconomic variables.

Assumption 3

Purchasing power parity (PPP) obtains at all times.




The exchange rate in this ultra-simple model is theratio of the money stock to the demand, measuredat the foreign price level. Whatever serves to raisethe ratio, in other words to increase the numeratoror decrease the denominator, will cause the priceof foreign exchange to rise (the domestic currencyto depreciate).

The effect on this equilibrium of three types of

disturbance; a monetary expansion and a rise inreal income respectively in the domestic economyand an increase in the world price level.




Money Supply Increase Under Floating Exchange RatesIt is easy to see how great a depreciation is required torestore equilibrium. With domestic prices higher inproportion to the monetary expansion and the foreign

price level unchanged, preservation of PPP implies anincrease of the same proportion in the price of dollars.

Proposition

In the monetary model, a given increase in the domesticmoney supply leads, other things being equal, to a

depreciation of the same proportion in the value of thedomestic currency.




Income Increase under Floating Exchange Rates

PPP is preserved by appreciation, so that the fall in theprice of UK output is offset by a rise in the price of sterling relative to the dollar.

PropositionIn the monetary model, a rise in domestic real incomeleads, other things equal, to an appreciation of the homecurrency.




Foreign Price Increase Under Floating ExchangeRates

In the new equilibrium, the fact that local output ishigher priced in local currency terms than previously

is offset by the higher relative price of the foreigncurrency.

Proposition

In the monetary model, a rise in the foreign price

level, other things being equal, is associated with anappreciation of the domestic currency(that is a fallin the price of foreign exchange, S) and no otherchange in the domestic economy.




Under a fixed exchange rate regime, money supply isnot an exogenous variable.

Money Supply Increase Under Fixed Exchange Rates

The higher price level has made the domestic economy

uncompetitive, since, given unchanged foreign pricesand the fixed exchange rate, it amounts to a realappreciation.

There is an incentive for domestic entrepreneurs toimport from abroad and none for foreigners to buylocally produced goods




They avoid that outcome by using by using the foreignexchange reserves to buy the domestic currency or toput differently, to finance the ongoing payments deficit.The result is that the reserves start to fall.

Proposition

Under fixed exchange rates in the monetary model,starting from a position of equilibrium, domestic creditcreation will be neturatilized, other things being equal,by a fall in the reserves as a result of a temporary

balance of payments deficit. Conversely, domestic creditconstruction will cause a temporary balance of paymentssurplus and a consequent offsetting rise in the reserves.




Income Increase Under Fixed Exchange Rate Proposition

Under fixed exchange rates in the monetarymodel, starting from a position of equilibrium,

the result of a rise in (domestic country’s) realincome will be to cause an increase in thereserves as a result of a temporary balance of payments surplus, other things being equal. Inthe new equilibrium, the domestic money stockwill have risen and the home price level willhave returned to its PPP level.




Foreign Price Increase Under Fixed Exchange Rates

Proposition

Under fixed exchange rates in the monetary model,starting from a position of equilibrium, the result of a

rise in the rest of the world’s price level will be to causean increase in the reserves as the result of a temporarybalance of payments surplus, other things being equal.In the new equilibrium, the domestic money stock will

be greater and the home price level will have risen to itsPPP level.




Devaluation Under Fixed Exchange Rates Proposition

Under fixed exchange rates in the monetary model theresult of a once-and –for-all devaluation will be a

temporary improvement in the competitiveness of thehome country and, consequently, a balance of paymentsurplus, leading in turn to a rise in its foreign currencyreserves. However, the ensuing inflation will, as timepasses, erode the country’s price advantage, until the

economy finds itself back where it started, with a higherprice level, greater reserves and a larger nominal moneystock, but the same real money supply.


exchange rate determination model

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