Question

According to the monetary approach to exchange rate determination, how would an increase in foreign real income affect the value of domestic currency? In your explanation, discuss both the quantity theory and PPP

Answer 1

Let us understand this with a logical flow

A central bank of an economy print new currency to increase the money supply in the economy according to the assets it is having is the back, And foreign currency is one of those assets. So as the real foreign income rises, Foreign currency inflows will rise which will be translated into the increased money supply. Here comes the concept the of quantity theory of money which says that money supply and inflation are directly proportional i.e. if the money supply increases, Aggregate demand will increase and Aggregate output won't be able to match this demand soon resultingly prices will shoot up and inflation will rise. It is given by the following equation

M×V= P×Q

where

M= money supply

V= velocity of money i.e. how many times the money gets exchanged.

P= price level

Q = output

Q and V don't change in short term which make M and P directly proportional.

Now the inflation affects exchange rates adversely. Because rise of inflation leads to two impact first real interest rates in india falls and confidence of foreign investors gets reduced in the government of the country, Resultingly they withdraw their money from this economy which decreases the demand of the currency of the economy, resultingly exchange rate falls.

PPP theory supports this argument. It says that if a country is a relatively having higher inflation then its currency will be on depreciation. It is given by

E(r)= S0((1+iA)/(1+iB))

Where

E(r) = expected exchange rate in A/ B quotation

S0= current exchange rate in A/B quotation

iA = inflation rate in country A

iB = inflation rate in country B

So if iA >iB then currency A will be on depreciation and currency B will be on appreciation. And vice versa is also true.