Question

Even though in the short term, currency values may deviate from the longer-term fundamental path. In the long term however, the exchange rates do appear to follow a fundamental equilibrium path, one that is consistent with the fundamental theories of exchange rate determination. There are three major schools of thought to explaining the economic determinants of exchange rates: parity conditions, the balance payments approach, and the asset market approach. Discuss the strengths and issues of each. Explain which is most relevant to explain the value of Ringgit Malaysia.

Answer 1

The three models of exchange rate determination are Purchasing Power Parity theory, the Balance Payment Approach, and The Asset Market Approach.

The theory of Purchasing Power Parity states that the exchange rate is determined as the relative prices of goods and services in the economy. It is the oldest and most widely used exchange rate theory. However, the calculations and forecasts under this theory have issues related to the structural differences across countries and challenges in collecting the data in estimation. The PPP failed to hold in the short to medium term and it ignored other factors of exports and imports in the economy. Another issue related to PPP theory is that the goods traded internally have no direct relationship with the exchange rate of the currency.

Balance of Payments (Flows) approach states that the exchange rate is determined through the demand and supply of currency flows from current and financial account activities. This theory works when the BOP data is readily available and widely reported. Critics may argue that this theory does not consider stocks of currency or financial assets of residents. It is covered in the monetary approach. BOP approach is valid only when all the sources of demand and supply of foreign exchange are considered. It failed to consider the entire forces which determine the flow of transactions across the countries.

Asset market approach considers the exchange rate as the relative price of money or bonds. This Approach states that the supply and demand for currency stocks, and the expected growth rates of currency stocks, will together determine the general price level or the inflation rate in the economy and thus determines exchange rates.

It adjusts the stock of currencies by linking the demand and supply of currencies with residents’ behavior. Critics tell that there are many other factors which affect the money demand. This approach fails to consider such factors like boom or recession in the economy.

The theory of Purchasing Power Parity is most relevant to explain the value of Ringgit Malaysia. It explains the relationship between exchange rate and inflation level. Law of one price states that identical goods should have equal price in any market or country.