Monetary Approach to Exchange Rate

11 Key excerpts on "Monetary Approach to Exchange Rate"

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  The Role of the Current Account in Asset Market Models of Exchange Rate Determination

  • Alexander Groß(Author)
  • 2019(Publication Date)
  • De Gruyter

    (Publisher)

  15 2. The Monetary Approach 2.1. Long Run: Purchasing Power Parity The Monetary Approach to Exchange Rate determination is based on the fundamental idea that the valuation of a foreign currency in terms of our own ... mainly depends on the relative purchasing power of the two currencies in their respective countries. This classical definition of absolute purchasing power parity by Cassel builds the foundation of monetarist exchange rate theories. The monetary approach adds to that statement the equally classical proposition that the quantity of money simultaneously determines the overall price level and the exchange rate. Prices and exchange rates are both considered as endogenous variables. This way of thinking leads directly to the definition of the exchange rate as the relative price of domestic and foreign currencies which is determined by the 2) relative supply of and demand for money. To illustrate the role of real variables within this framework, we start off with the law of one price. 1) Cassel (1922, p. 138). Although Cassel is credited for inventing the term purchasing power parity, the roots of this theory go back, according to Einzig (1970, p. 145), to Spanish economists writting in the 16th and 17th century. 2) For a detailed description of different versions of PPP see Officer (1976a). The monetary approach is explicitly derived from PPP theory by Frenkel (1976, 1978), Myhrmann (1976), and Mussa (1976). 3) The following exposition is taken from Claassen (1980, pp. 423). For a similar presentation see Dornbusch (1976a), for a graphical analysis Clements (1981). It is not intended to define PPP only in terms of traded goods, which is done sometimes.

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  Theory And Empirics Of Exchange Rates, The

  • Imad A Moosa, Razzaque H Bhatti(Authors)
  • 2009(Publication Date)
  • World Scientific

    (Publisher)

  CHAPTER 7 The Monetary Model of Exchange Market Pressure 7.1. Introduction The monetary model may be viewed as a dual relation that offers a mon-etary explanation for (i) movements in the external value of a country’s cur-rency when exchange rates are flexible and (ii) disequilibrium in a country’s balance of payments when exchange rates are fixed. 1 Based onWalras’s law, monetary models view the money market as a reflection of all other markets taken jointly, where excess supply of domestic money reveals itself as excess domestic demand for goods, services, and securities. Excess supply of domestic money spills into foreign markets, eventually leading to cur-rency depreciation or a deficit in the balance of payments. As an exchange rate model, the monetary model yields an exchange rate equation derived from equilibrium monetary conditions, the quantity theory of money, and purchasing power parity. Being the relative price of two national monies, the equilibrium exchange rate is determined in terms of the demand for and the supply of two national monies. The monetary model predicts that excess of domestic money supply over domestic money demand relative to foreign money leads to a propor-tional rise in relative prices, which in turn leads to a proportional rise in the exchange rate as a result of the neutrality of money. As a model of the balance of payments, it assumes a small country facing fixed exchange rates and employs the same monetary building blocks to produce a reduced form equation for the balance of payments. It shows that, under fixed exchange rates, an increase in domestic credit leads to a proportional reserve outflow and a rise in domestic prices, thereby maintaining the neutrality of mon-etary policy over time. The only difference between the monetary model of exchange rates and that of the balance of payments lies in the way 1 See Frenkel (1976, pp. 200 and 201) and Mussa (1976, p. 231). 206

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  Globalization, Gating, and Risk Finance

  • Unurjargal Nyambuu, Charles S. Tapiero, Unurjargal Nyambuu(Authors)
  • 2017(Publication Date)
  • Wiley

    (Publisher)

  These are also specified in Frankel (1979, 1984). As a result, the exchange rate ln(ξ $€) depends on the relative supply of money M $ / M €, relative income Y $ / Y €, and expected inflation differential between two countries. For example, for each of these approaches, considering the USA ($) and Europe (€), we have the models given in Table 5.4. Table 5.4 Asset and monetary approaches for the FX determination. Asset approach Monetary approach USA: USA: EU: EU: UIP: PPP: or Expected changes: Combined Equation A: (as in Frenkel (1976)) Equation B: (as in Bilson (1978)) Money demand: and 5.5.4 Empirical Evidence on the Monetary Model of Exchange Rate Frenkel (1976) applied the monetary approach to the determination of an exchange rate in a hyperinflationary period based on pre‐World War II data in Germany. Frenkel assumed that the demand for real money is a function of expected inflation, and a fixed foreign price (). An estimate of the effect of the nominal money stock M and inflation expectations π c on the exchange rate ξ using a log‐linearized equation was derived from Equation A in Table 5.4 (Frenkel, 1976) with an error term e :. Empirical findings were then shown to be consistent with the monetary exchange rate model. Similarly, assuming flexible prices, Bilson (1978 : 55) tested the monetary approach by estimating the following equation assuming that “an actual exchange rate adjusts toward the equilibrium rate”: where M is money demand, r is interest rate, and Y is real income. He also claimed that the monetary approach can also be used for a short‐term analysis. Empirical studies of the FX rate based on the monetary approach have pointed to a cointegration between exchange rate movements and their driving forces on fundamental macroeconomic variables. 4 These variables (e.g., money supply M and output Y) were shown to be nonstationary. Using panel data for 14 countries between 1973 and 1994, Groen (2000) studied a long‐run monetary and exchange rate model

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  Flexible Exchange Rates

  • Jan Herin(Author)
  • 2019(Publication Date)
  • Routledge

    (Publisher)

  A MONETARY APPROACH TO THE EXCHANGE RATE: DOCTRINAL ASPECTS AND EMPIRICAL EVIDENCE Jacob A. Frenkel* University of Chicago, Chicago, lliinois, USA and Tel-Aviv University, Tel-Aviv, Israel Abstract What, then, has detennined and will detennine the value of the Franc? First, the quantity, present and prospective, of the francs in circulation. Second, the amount of purchasing power which it suits the public to hold in that shape. Keynes (Introduction to French edition, 1924, xviii). This paper deals with the detenninants of the exchange rate and develops a monetary view (or more generally, an asset view) of exchange rate determination. The first part traces some of the doctrinal origins of approaches to the analysis of equilibrium exchange rates. The second part examines some of the empirical hypotheses of the monetary approach as well as some features of the efficiency of the foreign exchange markets. Special emphasis is given to the role of expecta-tions in exchange rate detennination and a direct observable measure of expecta-tions is proposed. The direct measure of expectations builds on the information that is contained in data from the forward market for foreign exchange. The empirical results are shown to be consistent with the hypotheses of the monetary approach. Introduction This paper deals with the determinants of the exchange rate. The approach that is taken reflects the current revival of a monetary view, or more gener-ally an asset view, of the role of the rates of exchange. 1 Basically, the monetary approach to the exchange rate may be viewed as a dual relationship to the monetary approach to the balance of payments. These approaches emphasize the role of money and other assets in determining the balance of payments * I am indebted to John Bilson for comments, suggestions and efficient research assistance. In revising the paper I have benefited from helpfuliiBBistance from R. W. Ba.nz and useful suggestions by W. H. Branson, K.

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  Balance of Payments Adjustment

  Macro Facets of International Finance Revisited

  • Augustine C. Arize, Theologos H. Bonitsis, Ioannis Kallianiotis, Krishna Kasibhatla, John Malindretos(Authors)
  • 2000(Publication Date)
  • Praeger

    (Publisher)

  The results will be a change in the direction of trade: exports will rise, imports will fall, and the trade balance will improve. The law of one price does not allow for changes in relative prices, rejects the elasticities approach, and renders inoperative the var- ious policies aimed at changes in relative prices. The Monetary approach as- certains that nominal variables affect only nominal variables and real variables affect only real variables. Thus, nominal variables such as prices and exchange rates cannot impact on real variables such as relative price and the trade balance. There are distinct differences between the Traditional approach and the Mon- etary approach in predictions and in policy implications, especially as they relate to exchange rate change and commercial policy. Exchange Rate Changes The Monetary approach argues that changes in the exchange rate do not affect the trade balance or any other real variable, but they impact the balance of payments through possible effects on the demand for, and the supply of, the money balance and the resulting changes in domestic prices. Devaluation A devaluation of a nation’s currency raises the domestic prices, exportables, importables, and, to a lesser degree, the trade of nontradables (product substi- tution). This general price rise increases the demand for monetary balances, which, if not satisfied from domestic sources, will be satisfied through money inflows from abroad, resulting in a balance of payment surplus. Devaluation reduces real domestic money balances and forces residents to seek to restore monetary equilibrium through the international markets, resulting in an effect that is only transitory.

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  Global Imbalances, Exchange Rates and Stabilization Policy

  • A. Makin(Author)
  • 2009(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  143 9 Monetary Policy and the Real Exchange Rate Introduction The conduct and effectiveness of monetary policy has changed markedly over recent decades as capital markets have become more internationally integrated, external imbalances have widened and exchange rates have become more variable. Inflation targeting is also now a primary goal of monetary policy in many advanced and emerging economies. Yet in this financially globalized context, many unresolved questions remain about the nature of the monetary policy transmission mechanism under floating exchange rates. For instance, how does a change in the monetary stance influence real exchange rate adjustment and external imbalances? How do inflationary expectations at home and abroad affect inflation and the real economy? How important are changing interest risk premia and foreign interest rate movements to domestic monetary policy settings? And how do cyclical and productivity shocks in the real sector affect competitiveness, the current account and inflation over the medium term? This chapter aims to provide clear-cut answers to these questions with reference to an international macroeconomic framework that links aggregate production, aggregate demand, interest rates, exchange rates, expectations, domestic and foreign price levels and external account imbalances. This distinct approach contrasts with more traditional interna- tional monetary models that incorporate transnational capital flows, such as the MF framework which is widely used for interpreting the 144 Global Imbalances, Exchange Rates and Policy impact of real and monetary shocks in open economies. The MF model remains central to textbook macroeconomics and has proven so durable because it delivers clear macroeconomic policy prescrip- tions about national income stabilization under alternative polar exchange regimes.

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  Central Bank Policy

  Theory and Practice

  • Perry Warjiyo, Solikin M. Juhro(Authors)
  • 2019(Publication Date)
  • Emerald Publishing Limited

    (Publisher)

  The elucidation of Article 10, paragraph (1), letter b, point 1 of the BI Act also states that OMO include foreign exchange market intervention by Bank Indonesia to stabilize the rupiah. 4.5. Concluding Remarks This chapter has discussed, in depth, monetary policy and theory in an open economy, particularly through the exchange rate and its impact on the economy. First, the theoretical and empirical studies demonstrate that exchange rate fluctuations are influenced by fundamental factors, such as money supply, the interest rate, BOP and economic growth, as well as foreign exchange market microstructure dynamics, specifically order flows and information heterogeneity. Although long-term exchange rate dynamics can be explained by fundamental factors, short-term developments are extremely volatile and difficult to predict. Therefore, the exchange rate not only influences inflation and growth, but the volatility can trigger monetary and financial system instability. Second, the exchange rate correlates positively with the trade balance and, therefore, economic growth. Theoretically, this occurs if the Marshall–Lerner condition is met, such as if export elasticity to the real exchange rate exceeds the corresponding import elasticity. Empirically, however, that positive exchange rate effect can be observed to increase in countries where the export structure is dominated by competitive and hi-tech commodities, as part of the international trade chain, and the domestic industry structure can reduce dependence on imports. The use of exchange rates to boost competitiveness and, thus, improve the trade balance and stimulate growth is often a polemic in international economic politics, which has manifested in the ongoing debate on currency wars

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  Applied International Economics

  • W. Charles Sawyer, Richard L. Sprinkle(Authors)
  • 2020(Publication Date)
  • Routledge

    (Publisher)

  CHAPTER 15

  Money, interest rates, and the exchange rate

  When U.S. interest rates have been significantly higher than foreign rates, capital has tended to flow to the United States, raising the value of the dollar; conversely, when U.S. interest rates have been significantly below foreign rates, capital has tended to flow abroad, depressing the dollar … the depreciation of the dollar in the late 1970s reflected, among other factors, our expansionary monetary policy. … The reversal of the dollar’s decline in 1980 and its unprecedented appreciation through the middle of the decade reflected major change in U.S. macroeconomic policy … [T]he Federal Reserve initiated policies that led to a substantial rise in U.S. short-term interest rates.

  Economic Report of the President

  INTRODUCTION

  S o far, we have examined the institutional details of the foreign exchange market and explained what determines the exchange rate. The model of exchange rate determination developed in the previous chapter explains some of the movement in exchange rates. Both the rate of inflation and the growth rate of GDP usually do not change dramatically over short periods of time, such as one day to the next. Yet, exchange rates change almost every minute of every business day. As a result, we need to expand our model of exchange rate determination to include another factor that determines or influences exchange rate movements over short periods of time. This factor is short-term interest rates. Since interest rates have an important influence on the exchange rate, we need to describe what causes domestic interest rates to change. In the first part of the chapter, we will review and expand on what you learned in your Principles of Economics course concerning the supply and demand for money and the determination of the equilibrium interest rate within a domestic economy.

  In the second part of the chapter, we will examine the relationship between interest rates and the exchange rate. As we will see, any change in interest rates will lead to changes in the inflows and outflows of capital in a country’s financial account and the changes in capital flows lead to changes in the exchange rate. By the end of the chapter, we will be able to examine how changes in interest rates, the exchange rate, the current account, and the financial account all interact with one another.

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  Macroeconomic Analysis and Policy

  A Systematic Approach

  • Joshua E Greene(Author)
  • 2017(Publication Date)
  • WSPC

    (Publisher)

  III. THE APPROACH TO MONETARY POLICY: ALTERNATIVE MONETARY FRAMEWORKS

  As Figure 8.1 has noted, economies can choose among several options for intermediate targets of monetary policy. Each of these intermediate targets implies a different framework for monetary policy.

  A. Exchange Rate Targeting (Using the Exchange Rate as a Nominal Anchor)

  One such framework involves exchange rate targeting. In this framework the monetary authorities use their policy instruments to maintain the nominal exchange rate at a certain level, or within a certain range, of a particular currency or currency basket. For example, the Hong Kong Monetary Authority uses its policy instruments to link the HK dollar to the U.S. dollar within a narrow band around US$1 = HK$7.80. The authorities intervene to prevent the HK dollar from depreciating below US$1 = HK$7.85 or appreciating above US$1 = HK$7.75.

  Until the past few decades, exchange rate targeting was arguably the most common monetary framework. Under the pre-World War II gold standard, for example, countries committed to ensure a certain relationship between their currencies and gold, or between their currency and another currency such as the British pound or the U.S. dollar that was pegged to gold. A similar rule applied under the Bretton Woods regime of 1945–1971, under which major world currencies were pegged at a fixed rate to the U.S. dollar and the U.S. dollar in turn was pegged to gold at US$35 per ounce. The European Exchange Rate Mechanism of 1979–1992, in which various currencies were linked at fixed exchange rates to the Deutsch (German) Mark, required the countries participating to commit their policy instruments to maintaining the exchange rate. Today, fewer countries maintain an exchange rate anchor for monetary policy. Nevertheless, as recently as April 2016 some 82 IMF member countries used an exchange rate anchor as their monetary framework. Thirty nine countries were linked to the U.S. dollar; 25 to the Euro, nine to some other currency, and nine to a basket of currencies. Of these 82 countries, 14 had no currency of their own, with eight using the U.S. dollar as legal tender.1

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  The Development of International Monetary Policy

  • Christopher Warburton(Author)
  • 2017(Publication Date)
  • Taylor & Francis

    (Publisher)

  6  Exchange rates as monetary policy tool

  International trade and monetary policy are inextricably linked through the exchange rate and net exports channels. While it has been a traditional policy to use the money supply and interest rate to stabilise economies, the exchange rate could also be used to obtain some measure of price stability and sustainable economic growth. The literature reflects that Singapore has embarked on such a policy with reasonable successes since 1981.

  Singapore has demonstrated that for a small open economy with substantial capital flows, the exchange rate can be used as an intermediate target of monetary policy. Intervention in the foreign exchange market is carried out with price stability as the ultimate medium term (six months) target. The Monetary Authority of Singapore (MAS) uses four main mechanisms to achieve its stabilisation objectives by exchange rate adjustments: (i) the domestic currency (Singapore dollar) is managed against a basket of currencies owned by major trading partners and competitors; (ii) the MAS operates a managed float (the trade-weighted rate is allowed to fluctuate within a policy band);1 (iii) the exchange rate policy band is periodically reviewed to ensure that it remains consistent with the underlying fundamentals of the economy to avoid misalignment in the value of the currency;2 and (iv) the MAS uses exchange rates in lieu of money supply and interest rates as monetary policy.

  Notably, the exchange rate has been an effective anti-inflation tool for the Singapore economy. Over the past twenty years or so (since the exchange rate framework has been in place), domestic inflation has been relatively low, averaging 1.9 percent per annum from 1981 to 2010.3

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  Monetary Policy in Central Europe

  • Miroslav Beblavý(Author)
  • 2007(Publication Date)
  • Taylor & Francis

    (Publisher)

  This chapter contains analysis of developments of nominal and real exchange rates and their role in monetary policy of the Czech Republic, Hungary, Poland and Slovakia. It brings together various empirical results to form a unified explanation of the role of the exchange rate in monetary policy, with emphasis on actual behaviour of monetary authorities.

  Framework for analysis of exchange rate strategies

  This section sets the analytical stage for the following empirical sections in order to propose a framework for analysis of exchange rate choices and a resulting classification of exchange rate strategies in Central Europe with a view to application to other small open economies.

  The proposed framework for analysis of exchange rate choices is based on three considerations relevant for Central European countries: low inflation, predictability of nominal exchange rate and prevention of a real exchange rate misalignment.

  The medium-term aims of monetary policy in accession countries during the 1990s and in the early 2000s can be simplified to:1

  • low inflation, implying disinflation to a level fulfilling the Maastricht criteria and then consolidation of this achievement;
  • prevention of a major real exchange rate misalignment that would lead the economy into a currency crisis or require painful adjustment to avoid an outright crisis.

  The choice of a currency regime and a foreign exchange rate strategy in these countries, both in positive and normative terms, has been and will continue to be largely determined by answers to the following questions that influence the achievement of the objectives stated above:

  • What is the speed of disinflation chosen to achieve the low inflation fulfilling the Maastricht criteria?
  • What is the weight placed on the nominal exchange rate in the process of disinflation and then in consolidation of low inflation?
  • How risk-averse have policy-makers been about the prevention of real exchange rate misalignment, i.e. what levels do they consider dangerous and how prompt is the corrective action? (The issue is also related to management of capital inflows with regard both to disinflation and external imbalance.)

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