Theory of Exchange Rate Determination
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Theory of Exchange Rate Determination can be explained using different approaches. In the following section we have dealt with some of them.
Theory of Exchange Rate Determination can be explained using different approaches. In the following section we have dealt with some of them.
Determinants of Exchange Rates
- The Purchasing Power Parity or PPP happens to be one of the most significant approaches to determine exchange rate. PPP is primarily based on the “Law of One Price”. However, this law is based on the assumption that identical goods are sold at equal prices. It is a flow model of the balance of payment. This law lays down that exchange rate of currencies have to compensate for the differences in prices of goods. The Relative PPP approach continues to be applied till date. This approach lays down the fact the exchange rate has to compensate for the difference in inflation rate. PPP is not a very reliable determinant since changes in technology, commercial policies, labor force and tastes change the national productivity, which in turn changes the real exchange rate.
- The Balance of Payment Approach depends on the assumption that there exists an exchange rate and there exists internal and external equilibrium. The internal equilibrium is based on the assumption that there is full employment. The external equilibrium is the equilibrium in the balance of payments. This theory is more dependable as it can explain permanent deviations in PPP. This approach offers guidance on short term ups and downs. There are certain disadvantages of this approach. The model does not inform about the exact rate of unemployment. Next, the exchange rate does not maintain its consistency in accordance with the external accounts.
- Monetary and Portfolio Approach is an approach in which the prices of various domestic and foreign assets are decided. The agent is given a portfolio choice of various assets. The instruments, which are either money or bonds, have an expected return that could be invested. This investment opportunity determines the exchange rate. The opportunity of investment arises when the expected depreciation does not compensate the difference in exchange rates.
Thus these are the determinants of exchange rates.
