Question

Explain the monetary model of exchange rate, with reference to PPP and the quantity theory of money

Answer 1

The monetary model of exchange rate always relied upon purchase power parity and the demand for the money. Purchasing power parity is used to know the differences in the price of same product in the different country. As exchange rate is the relative price of two currencies, it is reasonable to consider the supply and demand of money be an important determinant of exchange rates. Exchange rates play a big role in the money transaction.

The monetary approach rests on the quantity theory of money in macroeconomics. The supply of money is controlled by the central bank of the country. In the quantity theory, money is for the purpose of medium of exchange. Money demand of an economy is directly proportional to the general price level and also the quantity of real output.We have to check the changes in the exchange rate because it is connected with the demand of the money. Countries always try to increase the demand of their particular currency.Incase of open economy side, the exchange rate must appreciate, making the local products more expensive, to preserve the PPP equilibrium. So we can conclude that a rise in gross domestic products will leads to appreciation of the domestic currency, given other thing else constant.

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