Theories Of Currency Exchange Rate Determination

Different research studies have produced different estimates for the currency exchange rate determination. But all these studies are not suitable for forecasting the movement of currency exchange rate in the market.

The currency exchange rate theory can be classified as: partial equilibrium models, general equilibrium models and disequilibrium or hybrid models. Partial equilibrium models include relative PPP and absolute PPP, which only consider the goods market; and covered interest rate parity (CIRP) and uncovered interest rate parity (UCIRP), which only considers the assets market, and the external equilibrium model, which states that the exchange rate is determined by the balance of payments.

The three main Theories of Currency Exchange Rate discussed here are: purchasing power parity also known as PPP, Theory of Elasticities and Modern monetary theories on short-term exchange rate volatility.

Purchasing Power Parity (PPP):

The theory of purchasing power parity is also known as Inflation Theory of Exchange Rates. According to this theory the price of one good should be equal to the price of the same good in another country, exchanged at the current rate and this is known as Law of One Price. The PPP theory in Currency Exchange rate determination has two different versions: the absolute version and the relative version.

Absolute PPP theory first dealt with the price relationship of goods in different currencies. Very strong preconditions are required by this theory. According to the absolute version, the exchange rates are equal to the ratio of the two countries and general price levels, which is the weighted average of all goods produced in a country. However, this version can work only if two countries produce or consume the same goods.

Also according to the Currency exchange theory with absolute version the transportation costs and trade barriers are insignificant. However, transportation costs are significant and always different across the globe. Also under this theory the brand names were disregarded. The absolute PPP is considered as a partial equilibrium theory and not the general one because it doesn’t deal with the money markets and the balance international payments.

General Version Of Absolute PPP(Relative PPP)

Relative PPP was developed as a more general version of the absolute PPP. It describes the relationship of prices with the exchange rate different economies. It had been assumed that the transactional costs are related proportionately to price level in order to generate the relative PPP.

According to the relative version, the percentage change in the currency exchange rate in a given time period should be equal to the difference between the change in the domestic and the foreign price level. The relative PPP has its shortcomings too because of the fact that the currency exchange rates move independently of the changes in the domestic prices and the foreign prices.

Theories of elasticity in currency exchange rate determination: The theory of elasticity tells us that the currency exchange rate is the price of foreign exchange with the help of which the equilibrium for the balance of payments is maintained. It can also be defined as, the extent to which the exchange rate in currency exchange rate theory responds to a fluctuation in the trade depending entirely on the elasticity of demands to the change in prices The elasticity approach in theory of currency exchange rate is not reliable as the exchange rates vary very frequently changing the rules of the game.

Modern monetary theories on short-term exchange rate volatility This theory takes into account the role of short term capital markets and the impact long term impact of commodity markets on the foreign exchange. The variations in the exchange rate and the purchasing power parity are because of the supply and demand for financial resources and the international capability. As per one of the theories the exchange rate volatility is elicited by an increase in supply of domestic money, because this certainly raises the expectations of higher future monetary growth.

The capital markets are included in the Purchasing Power Parity by extending the theory. According to another approach in the currency exchange theory, the exchange rate adjusts instantaneously in order to maintain continuous interest rate parity, but only in the long term to maintain PPP. Volatility occurs because the commodity markets adjust more slowly than the financial markets. This approach is referred as the dynamic monetary approach.

To conclude the theory of currency exchange rate determination it is important to consider all the traditional and modern approaches for the better understanding of the movements and the alterations that take place in the foreign exchange market. A short-term capital outflow assumed by a monetary shock creates imbalance in the payments requiring an exchange rate change in order to maintain equilibrium in payments. Speculative forces, asset markets disturbances, and the existences of short-term capital variations affect the exchange rate volatility. The degree of change in the exchange rate is a function of consumers' elasticity of demand. Because the financial markets adjust faster than the commodities markets, the exchange rate tends to be affected in the short term by capital market changes and in the long term by stock changes.