Monetary Approach to Exchange Rate Determination

The monetary approach happens to be one of the oldest approaches to determine the exchange rate. It is also use as a yardstick to compare the other approaches to determine exchange rate. The monetary model assumes a simple demand for money curve. The purchasing power parity or the law of one price holds true. The monetary model also assumes a vertical aggregate supply curve. A vertical aggregate supply curve does not imply constancy in the output but a flexible price.

Now let us begin with the model.

According to the absolute purchasing power parity the exchange rate is obtained by dividing the price level of the home country with that of the foreign country.i.e. P = eP*, P stands for the domestic price level and P* the foreign price level. e is the exchange rate.

The demand for money equation is given by
Md = kPyWhere k is constant and y is the real income level

In equilibrium,

The demand for money, Md =Ms , the supply of money

Hence at the point of intersection of the aggregate demand and the aggregate supply curve,

kPy=Ms

or, P = Ms / ky

or eP* = P = Ms / ky

or, e = Ms / P*ky

At this point external equilibrium is obtained in the economy. It is also clear fro the above equation that an increase in the money supply within an economy would lead to appreciation of the domestic currency. Conversely, international price level a well as the output level related inversely with the exchange rate.

Let us consider a situation where keeping all parameters fixed money supply rises in the domestic economy. Since prices are kept constant, excess money supply injects higher demand for goods and services within the economy. In the face of a fixed output, prices are pushed up. This will be accompanied by depreciation in the nominal exchange rate.

In the above discussion we have explained the determination of exchange rates under a flexible regime. In a fixed regime the economy takes a somewhat different course.

Let us say that the foreign price level has increased, ceteres paribus. There is also excess demand for goods that are produced in the home market. This in turn causes a balance of payment surplus. Foreign exchange reserves will rise along with an increase in the money supply. The rise in the supply of money would lead to a rise in the domestic price level and competitiveness in the economy will be as before.