The three models of exchange rate determination

The three deterrent examples of deputize come in determinationAbstractThis paper presents three toughies of stand in regulate determination. Each mystifys be based on the correspondence of foodstuffs in the international economy. The equilibrium of goods food market determine put back roam according to purchasing power parity the equilibrium of capital market determine veer browse according to pecuniary model the equilibrium of asset markets determine ex modification place according to portfolio model.IntroductionIt is in the interest of a variety of parties to understand the determining(prenominal)s of swop pass judgment. For economists, it is for their bright and academic pursuit to uncover the economic mechanism determining exchange rates. Policymakers would akin to understand the impacts and consequences of exchange rates to the policies and vice versa. Finance managers would like analyze the thorough factors determining exchange rates and integrated thes e factors in their financial or investment decision making. Speculators in abroad exchange market would like to know the direction of exchange rate movement aforehand to make profit. In the following, we explain three models of exchange rate determination, namely, the purchasing power parity( palatopharyngoplasty), the mvirtuosotary model and the portfolio respite theory.Purchasing Power ParityThe hypothetical surmisal of Purchasing Power Parity starts from the Law of One Price. The Law of One Price in open economy states that, if the market is competitive, no transaction cost and no barriers of trade, then identical products in different countries should be sold at the corresponding legal injurys, adjusted by exchange rate, i.e. under the equivalent currency denomination. Otherwise, in that respect is arbitrage opportunity. In nonation,pi =spi* (1)for pi = outlay of good i at theater country, pi*= price of good i at hostile country, s = exchange rateFor example, the pr ice an apothecaries ounce of gold quoted at London in GBP should be the same as an ounce of gold quoted at New York in USD times exchange rate of GBP/USD.Next, we consider a model with two countries. Both of them invite the floating exchange rate-regimes and Law of One Price holds for all goods in the two counties. Then, the world(a) price aim of stand country is should be the same as the habitual price level of conflicting country, adjusted by exchange rate. In nonation,P=sP* (2)for P= popular price level at home country, P*= general price level at conflicting countryP and P*, the general price level is the weighted average of all prices of goods. So if (1) holds for all goods, (2) will holds. (2) is what we called the absolute Purchasing Power Parity (absolute palatopharyngoplasty) the general price level of any country should be the same if adjusted to the same currency. In other words, the exchange rate should be fixed by the relative price level of two countries. I f you croup use $1 of home currency to bargain for a basket of goods at home country, then the $1 converted to remote currency should be able to buy the same basket of products in unconnected country, i.e. they have the same purchasing power.We can interpret that palatopharyngoplasty is a long- manoeuvre equilibrium level of exchange rate that in that respect is fundemental force of demand and supply in goods market to retain it. For example, assume that the home(prenominal) price level is higher than the inappropriate price level under the same currency measure, i.e. P sP*. If goods be identical and there is transaction cost and barriers of trade, then consumers from internal country will not buy local products. They will use their domestic currency to exchange to foreign currency to buy foreign products, which is cheaper. The force of supply and demand of currency will drives down exchange rate to belittle. In turn, disparagement of exchange rate will lower the price o f domestic products(under the same currency measure) and then the PPP equilibrium, P = sP* is retained.Yet the absolute PPP to be too strict, economists considers a weaker form, called the relative PPP. It states that constituent changes in price levels of two countries determine the percentage change in exchange rate. In notation,P/P = s/s +P*/P* (3)The relative PPP is a weaker form of absolute PPP because if absolute PPP holds real, the relative PPP holds true too but not vice versa. Moreover, change in price level is indeed the inflation rate. The relative PPP implies that exchange rate should be adjustede/e to the difference between two countries inflation rates. For example, a country with hyperinflation should storm comforting depreciation in its currency.Empirical SupportThe Purchasing Power Parity states that relative price level is a fundamental determinant of exchange rate. An data-based test would like to see whether there is such(prenominal) a relationship in histo rical data. The PPP hypothesis has be enormously and extensively tested empirically by economists. The extensive tests by economists found rattling little empirical bet on to PPP. Exchange rate and the relative price level are un related to in short run and medium run. In the long run, results found that exchange rate would converge to the divinatory equilibrium observe from PPP, but at a very slow rate.At the first glace, PPP seems to be a too strict hypothesis that its assumption is unlikely to hold. In reality, there is transaction cost and barriers of trade. The general price levels indeed include non-tradable goods and different countries have different components in their general price level. These deviations of the theoretical PPP will cause the domestic price level and foreign price level not converges, but retain at some deviated level.Literature ReviewOfficer (1982) contains a detailed drumhead on the theoretical and empirical works on PPP at early stage. Rogoff (1996 ) provides a more than update survey on PPP and their empirical tests. Taylor Taylor (2004) uses more complete data and more decently econometric tests, as they describe, retain similarly result as introductory scholars.Mo wampumary modelAs exchange rate is the relative price of two currencies, it is reasonable to consider the supply and demand of currency be an important determinant of exchange rates. Introduction of bullion supply and money demand, two very fundamental macroeconomic variables, into our modelsThe monetary approach rests on the quantity theory of money in macroeconomics. Firstly, notes supply (Ms) is a quantity determined by the central bank. In the quantity theory, money is for the direct of medium of exchange. Money demand of an economy is directly proportional to the general price level and also the quantity of real output. For example, if the general price level is doubled, then the economy would need double occur of money for their transactions. The sa me idea holds for quantity of real output. Then,Md = kPy (4)Where Md is money demand, P is the price level, y is the real output and k is the velocity of money. In equilibrium, Money supply must(prenominal) be equal money demand, and soMs = kPy (5)By rearranging, we haveP= Ms/ky (6)By this form, we can interpret that given a level of real output of the economy and a given level of money supply determined by the central bank, the price level of the economy will be adjusted to Ms/ky.Let * denotes the foreign currency variables. We assume the quantity theory of money holds true to foreign country also. We haveMs*= k*P*y* (7)The second important assumption of the monetary approach is that PPP holds true. The exchange rate always attains its PPP equilibrium level, as in (2).In the monetary approach, we have three relationships of variables now the quantity money of home country, quantity money of foreign country, and PPP. Combining there three relationships and rearranging the three equ ations, we haveMs/ ky = S Ms*/ k*y* (8)The quantity theory of money and PPP are two building blocks of the monetary approach. The PPP tells us that at the long run equilibrium, the exchange rate should be equal to the ratio of home and foreign price level. The quantity theory of money marcoeconomics describes that price level of a country is related to money supply of central bank and real output of the economy. Combining them, the monetary approach think that exchange is determined by domestic and foreign money supply (Ms Ms*), domestic and foreign real output (y y*), and domestic and foreign velocity of money(k k*).An important implication of the monetary approach is that central banks money supply policy would have primary impact to exchange rate. sugar with the domestic central bank suddenly amplify the money supply by a substantial amount, with all other domestic and foreign variables keep unchanged. The quantity theory of money implies that the purloin of money supply wi thout increase in real output will drives up the domestic price level, which government agency inflation also. The increase in domestic price level will induce domestic mess to buy more foreign products and cause the exchange rate to depreciate. This is the same equilibrating mechanism described in PPP.We may consider the magnitude of depreciation of currency by increase of domestic money supply. harmonise to equation (x), exchange rate, s, is directly proportional to Ms. So in the monetary approach, a given percentage increase in money supply will leads to the same percentage of depreciation of currency.A congenital consequence of the above analysis is to see if foreign money supply would leads to what kind change of exchange rate. From equation (x), we can see that foreign money supply Ms* comes into determining the exchange rate. If the foreign central bank increase money supply, the foreign currency would depreciate as by our previous analysis. Then, in turn, the domestic cu rrency would appreciate relatively.On the other hand, we may consider the effect of an increase in real output on exchange rate in the monetary approach. Given a fixed level of money supply, real output increase will leads to lowering price level, as described in the quantity theory of money. Then, on the open economy side, the exchange rate must appreciate, making the local products more expensive, to preserve the PPP equilibrium. So we can conclude that a rise in real output(GDP) will leads to appreciation of the domestic currency, given other thing else constant.Empirical consequenceThe monetary approach is largely based on PPP. Given the failure of PPP on empirical testing, it is not difficult to imagine that empirical test on the monetary model of exchange rates should found little support. Extensive tests have been carried out to examine the relationship between exchange rate vs. money supply and exchange rate vs. real output. As representative, Frenkel (1976) and Meese Rogo ff (1983) shows little empirical support on the Monetary approach.Literature examineJohnson (1977) portrays a model treatment of the monetary model of exchange rates. Frenkel (1976) and Meese Rogoff (1983) are representative empirical works on the monetary approach.Portfolio Balance ModelIn the monetary model, the orbicular economy is simplified as having goods and money only, and money is the medium of exchange to buy domestic and foreign goods. Exchange rates are determined by the relative demand and supply of money, domestic and foreign.The portfolio balance model takes a promote step from the monetary model that there are investment assets in the global economy for people to hold. People would consider holding money, domestic assets and foreign assets alternatively on their portfolio balance. Then the relative demand and supply of these investment assets would determine the exchange rate.The portfolio balance model assumes there are three kinds of assets for people to alloca te their total wealthiness Domestic money (M), domestic join (B), and foreign bond (FB). Domestic money (M), pays no interest, is a riskless asset. In term of finance, the unhazardous rate is zero in this simplified model. Domestic bond and foreign bond are spoiled assets that payout with, with interest rate rand r* respectively. Then the actual interest rate individual receive from foreign bond is sr*.The portfolio balance model of exchange rate makes further assumption in crease with modern portfolio theory. Domestic bond and foreign bond are not perfect substitutes. Holding domestic and foreign bond together in the portfolio would reduce the unsystematic risk. So people would not obviously hold the bond with higher yield only, but hold a portfolio of domestic and foreign bonds. Moreover, the individuals, cosmos are risk-averse and so they would hold some portion of riskless asset, the money.The individuals have a total wealth of W would decide how to allocate them into mone y, domestic bond and foreign bond respectively based on his risk preference and the returns of different assets, as in modern portfolio theory. He would purchase more of one asset if the return of the asset increase, or if the return of the alternative assets decrease. In summary,Demand of money = M(r, sr*) is decreasing in r and sr*Demand of domestic bond = B(r, sr*) is increasing in r and decreasing in sr*.Demand of foreign bond = FB(r, sr*) is increasing in sr* and decreasing in r.Total wealth, the supply of mixed assets, would equal to the demand of various assets., such thatW = M(r, sr*) + B(r, sr*) + BF(r, sr*) (9)It means that, in equilibrium, there would be some equilibrium value of r, r* and s to balance demand and supply.To focus on the role of exchange rate in this model, we may consider r and r* as given to be stable by the bond markets and only the exchange rate varies. The equation above can be simplified asW = M(s) + B(s) + BF(s) (10)Then, there will be a value of s t o equalize the demand of various assets to total wealth. In other words, the exchange rate is determined by the equilibrium across the money, domestic bond and foreign bond markets in this portfolio balance model.Implications and evidence of portfolio balance modelOne of the virtually important implications from the portfolio balance model is that current account surplus will be associated with depreciation of currency. accepted account surplus must be associated with capital account deficit, which means that the country is a net purchaser of foreign assets. The demand of foreign bond increase and so exchange rate would depreciate for the equilibrium in asset markets to restore.However, as noted by Copeland (2008), the tests of portfolio balance model, is far from satisfactory.Literature reviewSeveral articles by Branson propelled the portfolio balance model, and include empirical evidence also. Branson (1983) provides a good account of summary.ConclusionsWe have reviewed three di fferent models on exchange rates. The PPP, the most fundamental one, claims that price level is the fundamental determinant of exchange rates in the long run. The market force of goods arbitrage would push the exchange rate to the equilibrium level that balance the purchasing power of the different currency to the same level. The monetary model incorporates the classical quantity theory of money in marcoeconomics with purchasing power parity. It predicts that money supply, determined by the central bank, and real output are the determinants of exchange rate. The third theory, the portfolio balance model extends the monetary model from considering the money market to the markets of a number of assets. Individuals demand each type of assets and exchange rate is determined as the equilibrium price of various asset markets.All of the models we discussed are laid on fundamental economic theory and are conceptually sound. Unfortunately, economists found little direct empirical support to these models.We should not consider rejecting these three models because of the lack of empirical support. Firstly, these three models are conceptually fundamental and shape our cerebration in exchange rates. They will be extremely useful when we extend our analysis with specifications in further detail and seek more specific implications in exchange rate. Secondly, these models portray the long-run equilibrium sort of the exchange market. It is difficult to consider the volatile, second-to-second changing exchange rate market behavior would be consistent with these models. There may exists random shocks to the exchange rate market that consistently propel the exchange rate to move in a random style and so the long-run equilibrium of the models cannot be attained.