Theories of exchange rate determination. THEORIES OF EXCHANGE RATES DETERMINATION: A REVIEW on JSTOR 2022-10-28

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The exchange rate is the price of one country's currency in terms of another country's currency. Exchange rates play a crucial role in international trade and investment, as they determine the relative cost of different goods and services across countries. As such, the determination of exchange rates is an important topic in economics.

There are several theories that have been proposed to explain how exchange rates are determined. These theories can be broadly classified into two categories: fundamental theories and behavioral theories.

Fundamental theories of exchange rate determination focus on the underlying economic factors that drive the demand and supply of different currencies. The most well-known fundamental theory is the Purchasing Power Parity (PPP) theory, which states that in the long run, exchange rates should be determined by the relative price levels of different countries. According to PPP, if the price level in one country is higher than in another country, the exchange rate between the two countries should reflect this difference. For example, if the price level in the United States is higher than in Japan, the dollar should be worth more than the yen.

Another important fundamental theory is the Interest Rate Parity (IRP) theory, which states that the difference in interest rates between two countries should be equal to the expected change in the exchange rate between the two countries. According to IRP, if the interest rate in one country is higher than in another country, investors will be attracted to the country with the higher interest rate, causing an increase in demand for its currency and leading to an appreciation of its exchange rate.

Behavioral theories of exchange rate determination, on the other hand, focus on the psychological and emotional factors that influence the demand and supply of different currencies. One well-known behavioral theory is the Adaptive Expectations theory, which states that people tend to base their expectations of future exchange rates on their past experiences. According to this theory, if the exchange rate has appreciated in the past, people will expect it to continue to appreciate in the future, leading to an increase in demand for the currency and causing its exchange rate to appreciate further.

Another important behavioral theory is the Anchoring bias theory, which states that people tend to anchor their expectations of future exchange rates to a certain point, such as a historical exchange rate or the current exchange rate. According to this theory, if the exchange rate is anchored to a certain point, it will be more difficult for it to deviate from that point, leading to exchange rate stability.

In conclusion, the determination of exchange rates is a complex process influenced by both fundamental and behavioral factors. Fundamental theories, such as PPP and IRP, focus on the underlying economic factors that drive the demand and supply of different currencies. Behavioral theories, on the other hand, focus on the psychological and emotional factors that influence the demand and supply of different currencies. Understanding these theories can help economists and policymakers better predict and understand exchange rate movements.

A Theory of Exchange Rate Determination on JSTOR

theories of exchange rate determination

The Purchasing Power Parity Theory 3. The mint parity theory of foreign exchange rate highlighted two important facts. The determination of equilibrium rate of exchange can be shown through Fig. The substitution of foreign bonds for domestic bonds results in an immediate depreciation of home currency. Static Theory: The theory is static in the sense that it ignores other determinants of exchange rate such as economic relations between nations, incomes and tastes of the people, etc. In the quantity theory, money is for the purpose of medium of exchange.

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Theories of Exchange Rates

theories of exchange rate determination

The rate of exchange will be in equilibrium when the purchasing power of money is equal in all the trading countries. These actions to balance portfolios will influence exchange rates. The evidence on balance is against this theory except in the long run. Difficulty Regarding Equilibrium Rate: According to this theory, the knowledge of base rate i. It is in the foreign exchange market that the exchange rate among different currencies is deterĀ­mined. In other words, the rate of exchange should be equal to the ratio of the outlay required to purchase a particular set of goods at home as compared with what it would be abroad. Start with the domestic central bank suddenly increase the money supply by a substantial amount, with all other domestic and foreign variables keep unchanged.

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Exchange Rate Determination

theories of exchange rate determination

Capital flows between countries also disturb their rate of exchange. To the extent that trade flows are a force in the market, competitiveness is obviously important to the exchange rate, and the many factors affecting competitiveness must be considered. . These ranges are determined by monetary and economic policies. Portfolio Balance Model In the monetary model, the global economy is simplified as having goods and money only, and money is the medium of exchange to buy domestic and foreign goods. Capital Movements Ignored: Keynes also points out that the purchasing power parity theory ignores the influence of capital movements.

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Top 3 Theories of Rate of Exchange: With Criticisms

theories of exchange rate determination

Thus the portfolio balance approach explains also exchange over-shooting. There are no costs for converting one currency into another currency conversion costs are zero. Known worldwide for their public meetings of international figures in trade and commerce, the Bretton-Woods Conference, the Louvre Agreement and the Smithsonian Agreement addressed complicated subjects like exchange rates. Under the gold standard, countries had their standard currency unit either of gold or it was freely convertible into gold of a given purity. The gold points are determined by the costs of shipping gold such as, transportation, packing, insurance charges from one country to another. In such a system, the mint parity theory cannot at all determine the rate of exchange. If however, the quoted forward rate is not the same as the forward rate calculated using equation 2, an investor can make a profit by borrowing in one currency, converting it into another currency, investing the proceeds, and covering himself against exchange rate risk.

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Determination of Exchange Rates: 5 Approaches

theories of exchange rate determination

Perhaps they use it because traders often have a very short-term time frame and are interested in very short-term moves. Most major economies are largely dependent on floating exchanges thanks to little government intervention. This theory states that the equilibrium rate of exchange is determined by the equality of the purchasing power of two inconvertible paper currencies. Exchange rates are the amount of one currency you can exchange for another. Although this theory can be traced back to Wheatley and Ricardo, yet the credit for developing it in a systematic way has gone to the Swedish economist Gustav Cassel. Speculation Every nation has money as an asset.

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Theories of Exchange

theories of exchange rate determination

Perhaps traders think technical analysis will be effective in part because they know many other market participants are relying on it. We assume the quantity theory of money holds true to foreign country also. These forces are influenced, apart from transactions of goods, also by such factors as capital flow, cost of transport, insurance, banking etc. Is covered interest arbitrage possible? Thirdly, this approach holds that domestic and foreign financial assets such as bonds are perfect substitutes. The exchange rate between the British pound and the American dollar was determined on the basis of the mint parity and was equal to the ratio of the gold content of the two currencies.

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Determination of Foreign Exchange Rate (Explained With Diagram)

theories of exchange rate determination

Thus, the upper gold point is determined by adding the cost of shipping gold to the mint parity rate of exchange and the lower gold point is obtained by deducting the cost of shipping gold from the mint parity rate of exchange. Crawling Pegs: As a result of the system, the Central Bank allows its currency to appreciate or depreciate gradually on international markets. In term of finance, the risk-free rate is zero in this simplified model. A country is said to be on inconvertible paper standard when- a money is made of paper or some cheap metals and its face value is greater than its intrinsic value; b the money is not convertible into gold; c the purchasing power of money is not maintained at par with that of gold or any other commodity; d the currency may not be fully backed by gold or any other metallic reserves; e the currency system is nationalistic in the sense that there is no link between the different paper currency systems adopted by different countries. In other words, the theory applies only to current account transactions and neglects the capital account completely.


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THEORIES OF EXCHANGE RATES DETERMINATION: A REVIEW on JSTOR

theories of exchange rate determination

That is, there are no trade barriers or quotas. It, thereby, assumed implicitly that there were zero capital movements. The two are inversely related. As regards, the supply of money, it is determined autonomously by the monetary authorities of different countries. Thus, the purchasing power parity theory is further limited as a guide to equilibrium exchange rates.


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What are the theories of exchange rate determination?

theories of exchange rate determination

Carry trades are more likely to go wrong in times of risk aversion, such as global economic instability and geopolitical uncertainty. However, the authorities will intervene if appreciation or depreciation are swiftly followed by one another. Research thus far has not been able to find stable and significant relationships between exchange rates and any economic fundamentals capable of consistently predicting or explaining short-term rate movements. Under such conditions, the rate of exchange between the two currencies must equalise the purchasing power of both the countries. Purchasing Power Parity Theory : Purchasing power parity theory explains the determination of exchange rate and its fluctuations when the countries are on inconvertible paper standard. This parity is again the purchasing power parity because it is determined by the quotients of the purchasing powers of the different currencies. It is the process of equilibrating the total demand for, and supply of, financial assets in each country that determines the exchange rate.

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