Question

1. Explicate the monetary approach to exchange rate determination.

2. Discuss the current account/balance of payments view to ER determination

3.Explain the portfolio balance approach to ER determination.

Answer 1

Ans1)The Monetary Approach to Rate of Exchange:

According to this approach, the demand for money depends upon the level of real income, the general price level and the rate of interest. ... As regards, the supply of money, it is determined autonomously by the monetary authorities of different countries.

Ans 2)

A current account deficit means import outweighing export hence fall in demand for export can reduce demand for domestic currency. Causing depreciation in floating exchange rate. Alternatively an increase in import means more money outflows from the economy.

A change in a country's balance of payments can cause fluctuations in the exchange rate between its currency and foreign currencies. The reverse is also true when a fluctuation in relative currency strength can alter the balance of payments. There are two different and interrelated markets at work: the market for all financial transactions on the international market (balance of payments) and the supply and demand for a specific currency (exchange rate).These conditions only exist under a free or floating exchange rate regime. The balance of payments does not impact the exchange rate in a fixed-rate system because central banks adjust currency flows to offset the international exchange of funds.

Ans 3)

The portfolio balance approach is an extension of the monetary exchange rate models focusing on the impact of bonds. According to this approach, any change in the economic conditions of a country will have a direct impact on the demand and supply for the domestic and the foreign bond. This shift in the demand/supply for bonds will in turn influence the exchange rate between the domestic and foreign economies.

The key advantage of the portfolio approach when compared to traditional approaches is that the financial assets tend to adjust considerably faster to news economic conditions than tradeable goods. Nevertheless, based on empirical evidence, the portfolio balance approach is not an accurate predictor of exchange rates.